Facing a Future Without the Clergy Housing Allowance

The latest constitutional challenge to the clergy housing allowance brought by the Freedom From Religion Foundation (FFRF) cleared its first significant legal hurdle in October, when a federal district court judge ruled the valuable longtime tax benefit for ministers to be an unconstitutional preference for religion. The parsonage allowance pertaining to church-owned housing remains unaffected.

The decision may now head to the Seventh Circuit Court of Appeals. Were the Seventh Circuit to affirm the lower court’s decision (a decision is expected to come during the second half of 2018), it would apply only to ministers in that circuit (Illinois, Indiana, and Wisconsin). It would become a national precedent binding on ministers in all states if (1) such a decision is ever affirmed by the United States Supreme Court, or (2) the Internal Revenue Service follows a Seventh Circuit affirmation to promote consistency in tax administration nationwide. Because the Supreme Court accepts less than 1 percent of all appeals, it is uncertain that the Court will agree to hear the case and, moreover, uncertain how the Court would rule. Absent a Court decision, it’s unclear how other federal circuits would address future litigation as well.

With the situation far from certain, churches nationwide should think through preparations now that would help ready their pastors were the clergy housing allowance ever to go away. Senior Editor Richard Hammar identifies three immediate implications of such an outcome that churches can address now:

1. Compensation. The sudden elimination of this tax benefit would immediately thrust many clergy into a dire financial position with a mortgage loan based on a tax benefit that no longer is available. Many church leaders would want to reduce the impact of such a predicament by increasing compensation, likely through some type of phased approach.

2. Tax payments. Many ministers would need to increase their quarterly estimated tax payments or voluntary withholdings to reflect the increase in income taxes in order to avoid an underpayment penalty.

3. Future home purchases. Ministers currently considering the purchase of a home should not base financing decisions on the availability of a housing allowance unless and until the courts conclusively rule in favor of the constitutionality of the allowance or their congregation is able to assure them that their compensation will be increased to compensate for the loss of the allowance.

We asked Ted Batson, tax attorney and CPA with the accounting firm CapinCrouse, to evaluate the financial and administrative aspects of these three implications, and provide additional recommendations as churches and pastors navigate this uncertain situation.

Let’s assume for a moment that the housing allowance is suddenly a lost benefit for all clergy. What would happen?

Many pastors who currently take advantage of the benefit will quickly figure out that they can’t make it on their current salaries. So churches will need to plan for the potential need to increase their pastor’s compensation. This includes asking the congregation to give more generously to support the increase. However, if the churches can’t increase their pay, these pastors will decide whether they have to (a) become bivocational, (b) find an opportunity at a church that will pay more, or (c) leave the ministry.

If a pastor chooses either of the last two options, it will put the current church in a bind because it most likely can’t afford to replace the pastor who has left or may have to accept a less qualified candidate. This could lead to other options for the church. For instance, a church could decide to consolidate with another church or share a pastor.

Let’s say a church wants to do what it can, in terms of compensation, to retain that pastor. How would it implement Hammar’s first recommendation?

If the housing allowance is invalidated in 2018, it could be difficult to take this step right away because a church might have very limited budget dollars available. And, if the case goes to the Supreme Court, the appeals process will take time; I don’t expect any final decision in that scenario until 2019 or 2020.

So, churches might consider now, in 2018 and 2019, setting aside a contingent reserve amount to help board members, other leaders, and the entire congregation get used to the notion that the church might have to pay the pastor a higher salary. That way churches would have the additional money needed in case the housing allowance is invalidated.

I’d also encourage churches to budget reserve amounts in “bite-size chunks” so that the budget can still handle it. For instance, budget one-third to one-half of the anticipated increase in the pastor’s compensation in cash reserves each year until a final decision is made. It lessens the burden of a sudden and big jump in the pastor’s compensation.

One thing to note: a salary increase wouldn’t need to match the lost housing allowance benefit dollar-for-dollar. Rather, the increase should focus on the increase in the pastor’s income tax liability resulting from the lost benefit since this is the amount the pastor will be out-of-pocket. For instance, in the case of the loss of a $20,000 annual housing allowance, the pastor’s increased tax liability is likely to be approximately $5,000. This would be the amount by which the pastor’s salary would need to increase to make up for the lost housing allowance benefit.

What if the housing allowance doesn’t go away and you’ve set aside all this money?

There are some who might say, “Why would you actually segregate the cash when you don’t need it?” And I’d say, “You’re saving it against the possibility. And then if, for instance, the courts eventually rule in favor of the allowance, you have a windfall you can use for some other purpose.”

If the pastor does need the additional compensation at some point, what about unreasonable or excessive compensation?

This should be a concern anytime you’re making a significant increase in a pastor’s compensation. For larger churches that compensate their ministers well, this could be a concern. But note that since all such churches will likely be increasing their pastors’ compensation, it is likely that the compensation in comparison with others will not be out of line. Of course, if you’re talking about pastors in small churches with tight budgets, you might have a long way to go before you would actually have to worry about penalties related to excessive compensation.

What if a church simply decides to start raising the pastor’s salary right now in anticipation of losing the housing allowance deduction?

The problem with gradually increasing the pastor’s compensation against the possibility of the housing allowance going away is that you are stuck with that decision. The pastor is receiving higher pay based on something that might not happen.

Creating a cash reserve that anticipates the possibility provides flexibility while not locking the church in. That seems to me like a better option.

Hammar also indicates the need to prepare for increased quarterly estimated tax payments or voluntary withholdings. What other affects may pastors feel?

I agree with Hammar about the need to increase quarterly payments or voluntary withholdings, and there are effects beyond just increased payments or withholdings: the potential increase in taxable income due to lost deductions. If a pastor’s adjusted gross income becomes more, because he or she is no longer able to exclude the housing allowance, the pastor might lose some other deductions that could have otherwise been claimed.

Consider, for example, the 2 percent of adjusted gross income threshold for miscellaneous itemized deductions. If my adjusted gross income is $100,000, 2 percent of that is $2,000. So if I have miscellaneous itemized deductions, which some pastors may have for unreimbursed expenses, under current rules, I am able to deduct those to the extent they exceed $2,000.

Now let’s say I had a housing allowance of $10,000. With an invalidation of the benefit, my adjusted gross income is $110,000 instead of $100,000. This means that I can only deduct those miscellaneous itemized deductions to the extent they exceed 2 percent of $110,000, or $2,200.

Note that the tax reform proposals currently in the House and Senate (as this issue was going to press) repeal many currently available itemized deductions, so this may be a moot point.

What are some specific ways the loss of the housing allowance would affect a pastor’s housing situation?

If pastors lose the housing allowance, I think it will be a real and immediate concern for a high percentage of ministers—maybe up to 80 or 90 percent of them. If you’re a pastor from a large church with a large budget, the church will be able to more readily absorb an increase in the pastor’s salary resulting from the loss of the housing allowance. But pastors in most small and medium-sized churches are going to have to make some lifestyle choices.

I would imagine there are pastors who have made certain housing choices because they have a housing allowance. They may have purchased furnishings for their home based on the housing allowance. Or they may have purchased a bigger home than they otherwise would have purchased, or made other similar decisions based on the availability of the housing allowance.

If the housing allowance goes away, pastors will need to rethink their personal budgets. Some pastors will say, “I can’t afford this 2,500-square-foot home. I’m now going to have to sell this one and buy a 1,900-square-foot home, because that’s all the mortgage I can afford with the loss of the housing allowance.”

To afford their current house, pastors may have to supplement their income with a second job or their spouse may have to find another job. Pastors also may have to give up on plans to construct an addition to their current home. They may decide not to renovate or buy new furniture. Maybe the lawn-care service will need to go. They may give up cable.

Again, there are a number of choices pastors will need to make—and some of them will be difficult. They may say, “We like this house. We like the neighborhood. We like the schools. Our children have friends here. We’re going to stay in this house even though it will stretch us financially. We’re going to give up other things. We won’t eat out as much. We will take less-expensive vacations.”

On top of that, it will affect other critical areas, like saving for retirement or for their children’s education. Pastors might not be able to put away as much for these future expenses as they want to.

It creates some challenging financial man-agement issues, doesn’t it?

Yes—for both the pastor and the church. If the housing allowance goes away, pastors will have to learn to manage their finances without this tax benefit.

Without the housing allowance, churches will be trying to come up with ways to help their pastor afford a home in the neighborhood where the church is located, because there is value in having the pastor live in the same community as the church. This might cause some churches to consider increasing compensation for the pastor as we have discussed. It also might cause some churches that don’t have a parsonage to consider purchasing one.

This also means pastors currently looking to buy should make a decision that keeps the possibility of this lost benefit in mind, right?

If you’re going to make an expenditure tied to the availability of the housing allowance, think carefully.

Pastors will have to weigh a number of lifestyle choices besides whether or not to take out a big mortgage.

Sorting Options amid Uncertainty

How should churches respond if the housing allowance is invalidated? Currently, my firm isn’t attempting to answer this question for the churches we serve. The case still has potential issues with legal standing, and the Seventh Circuit may remand the decision back to federal district court or overturn it. Additional issues exist with the effective date and who is affected by a ruling. When a circuit court rules on a tax issue, it is technically only binding on persons within that circuit. The IRS may or may not agree to enforce it as the law of the land. As to timing, the decision is effective when it is final, but could be stayed until the case is either taken up by the Supreme Court or denied certiorari by the Supreme Court. These factors delay any effective date of the ruling. We plan on providing guidance after the Seventh Circuit’s rules.

If the decision is upheld by the Seventh Circuit, and potentially the Supreme Court, churches will need to educate their ministers on the change and its ramifications. If the housing allowance is disallowed, Congress may adjust other laws to provide relief for some ministers or other existing laws may provide relief. Only the cash housing allowance is in dispute and not the provision of the parsonage. The parsonage may provide some avenues of planning in light of an adverse ruling.

A factor complicating this issue, and making recommendations difficult, is potential tax law reform under consideration. Proposed tax law changes might mitigate some of the housing allowance benefits through changes in itemized deductions. But, again, it is difficult to speculate.

Whatever the tax law landscape, churches can’t begin to determine potential budget additions without evaluating the effects on individual ministers. To evaluate the effect of the potential change on a minister’s taxes, and thus the potential effect on the church’s budget, a church should ask each minister to provide an estimate of the potential tax effects. A church may engage a professional to help with this analysis. Once the potential tax costs facing its ministers are determined, a church can begin to assess its actions to assist ministers in mitigating the tax effects.

When considering a new house purchase, ministers will need to evaluate the potential increase in taxes from losing the housing allowance. It is doubtful churches will be able to provide enough additional compensation to mitigate all the tax consequences of losing the housing allowance.

—Elaine Sommerville, editorial advisor and CPA and sole shareholder of the accounting firm Sommerville & Associates, P.C.