Warren v. Commissioner, 114 T.C. 23 (2000)
Background. In one of the most significant clergy tax cases in recent years, the United States Tax Court ruled that a housing allowance is nontaxable for income tax reporting purposes so long as it is used to pay for housing-related expenses. The court threw out the annual “rental value” test that the IRS adopted in 1971, which limited nontaxable housing allowances for ministers who own their homes to the “annual rental value” of their home. The court’s decision will have a direct and immediate impact on many ministers. Church treasurers should be familiar with the application of this ruling to their pastor or pastors. This article will tell you what you need to know.
The housing allowance. Section 107 of the Internal Revenue Code provides that “in the case of a minister of the gospel, gross income does not include … the rental allowance paid to him as part of his compensation, to the extent used by him to rent or provide a home.” This language requires very little explanation. The portion of a minister’s church-designated housing allowance that is used to pay for housing-related expenses is nontaxable for federal income tax reporting purposes. Stated differently, ministers may exclude from taxable income the lesser of (1) the church-designated housing allowance, or (2) the actual amount of housing-related expenses paid during the year.
Key point. There are certain technical requirements that must be met in order for a minister to qualify for a housing allowance exclusion. The allowance must be designated by official church action, and it must be designated in advance. Housing allowances cannot be declared retroactively. These and other requirements are reviewed fully in chapter 6 of Richard Hammar’s year 2000 Church and Clergy Tax Guide.
Unfortunately, in 1971 the IRS imposed an additional limitation on ministers who own their homes: the housing allowance exclusion may not exceed the annual rental value of the minister’s home (furnished) plus the cost of utilities. Revenue Ruling 71 280. Therefore, ministers who own their homes may only exclude actual housing expenses to the extent such expenses do not exceed either the church designated allowance or the fair rental value of the home plus the cost of utilities.
Key point. In Publication 517, the IRS explains how to compute the nontaxable portion of a housing allowance as follows: “If you are a minister who owns your home and you receive as part of your pay a housing or rental allowance, you may exclude from gross income the lowest of the following amounts: (1) the amount actually used to provide a home, (2) the amount officially designated as a rental allowance, or (3) the fair rental value of the home, including furnishings, utilities, garage, etc.”
The Tax Court case. A pastor of a large church wrote several best-selling books and operated a tape and book ministry. Since the pastor received substantial income from the tape and book ministry, his church designated all of his church compensation (between $75,000 and $100,000 per year) as a housing allowance. The pastor used all of these allowances to pay for housing expenses, and so both he and the church treated the allowances as fully nontaxable for income tax reporting purposes. However, the “annual rental value” of the pastor’s home was substantially less than his housing allowance or his actual housing expenses. He chose to ignore the IRS-imposed rental value test in computing the nontaxable portion of his housing allowance. As a result, he reported little or no taxable compensation for several years.
The IRS audited the pastor’s tax returns for three years and determined that he owed a significant amount of additional taxes because he failed to limit the nontaxable portion of his housing allowance to the annual rental value of his home (furnished, including utilities). The pastor appealed the IRS decision to the United States Tax Court.
The Tax Court (by an overwhelming vote of 14-3) threw out the annual rental value test, noting that the tax code does not limit the nontaxable amount of a minister’s housing allowance to the fair market rental value of the minister’s home. The language of the code is clear, and it imposes no “rental value” limitation.
The vast majority of pastors who will be helped by the court’s decision are not those with exorbitant incomes from outside sources (as some fear), but rather lower and middle income pastors who pay a down payment in the year they acquire a home, who have to make emergency repairs to their home, or who decide to remodel. Consider the following examples.
Example. Pastor C is paid a salary of $40,000 for year 2000. The church board designated $25,000 of this amount as a housing allowance. In February, Pastor C purchases a new home and makes a down payment of $15,000. Assume that he has additional housing expenses of $7,000 for the year, and that the annual rental value of the home (furnished, including utilities) is $10,000. Prior to the Tax Court’s recent decision, Pastor C’s nontaxable housing allowance would have been the least of the following three amounts: (1) the church-designated housing allowance ($25,000); (2) actual housing expenses ($22,000); or (3) the annual rental value of the home ($10,000). Since the annual rental value is the lowest amount, this would have been the nontaxable amount of Pastor C’s housing allowance. But why should this be so? The IRS insisted that the rental value limitation avoids “unfairness” by preventing ministers with other sources of income from having their employing church designate all of their church compensation as a housing allowance. But does this argument make sense in this example? Pastor C receives no substantial income from another vocation that allows his church to “unfairly” designate all of his church compensation as a housing allowance. In reality, it is “unfair” to apply the annual rental value test to Pastor C under these circumstances. Fortunately, 14 of the Tax Court’s 17 judges agreed.
Relevance to church treasurers. What is the relevance of the Tax Court’s ruling to church treasurers? Consider the following:
1. The status of the annual rental value test. Ministers should be informed that they can ignore the annual rental value test in computing the nontaxable amount of their housing allowance. The IRS is free to challenge ministers who ignore the annual rental value test, but ministers can rely on the Tax Court’s decision, which not only provides strong judicial support for their position but also protects them from penalties. If the IRS appeals the case and the federal appeals court for the ninth circuit affirms the Tax Court’s decision, then the IRS would not challenge ministers who ignore the annual rental value test in the states of Alaska, Arizona, California, Hawaii, Idaho, Montana, Nevada, Oregon, and Washington. Such a ruling would add even greater weight to the Tax Court’s decision, making it more likely that appeals courts in other federal circuits would reach the same conclusion. The IRS could appeal such a decision to the Supreme Court, but it is highly unlikely that the Supreme Court would review the case.
2. How much of a minister’s compensation can be designated as a housing allowance? The church in this case designated all of the pastor’s compensation as a housing allowance. The IRS insisted that the tax code prohibits the designation of all of a minister’s compensation as a housing allowance, but the Tax Court rejected this position.
There are many ministers who have most or all of their compensation designated as a housing allowance. Common examples would be bivocational pastors, pastors of small congregations or “missions” churches, and part-time associate pastors. Contrary to the IRS position, it is not “abusive” for churches to designate most or all of the income paid to these pastors as a housing allowance. The Tax Court’s decision will serve as strong legal support for the legitimacy of such housing allowances.
3. Impact on church boards. In most churches, the church board designates housing allowances. In some churches, a “compensation committee” or the congregation itself designates housing allowances. In any case, church leaders should recognize the impact of the Tax Court’s ruling on the process of designating housing allowances. Most importantly, the case will permit churches to designate larger housing allowances than were permissible in the past.
Example. A church board is considering the year 2001 compensation package for Pastor B. It decides on total compensation of $30,000. Pastor B informs the board that he will have ordinary housing expenses of $10,000, but that he also will be incurring remodeling expenses of an additional $10,000. The board is uncomfortable designating two-thirds of Pastor B’s total compensation as a housing allowance. According to the Tax Court’s recent decision, the board is free to designate two-thirds of the pastor’s compensation as a housing allowance.
Example. Pastor H is a part-time associate pastor at his church. The church board plans to pay him $10,000 for 2001. Pastor H asks the board to designate 100 percent of this amount as a housing allowance. The church treasurer is uncomfortable designating the entire amount as a housing allowance. According to the Tax Court’s recent decision, the board is free to designate all Pastor H’s compensation as a housing allowance.
Example. A church board is considering the year 2001 compensation package for Pastor N. It decides on total compensation of $60,000. Pastor N asks the board to designate this entire amount as a housing allowance. He informs the board that he will have ordinary housing expenses of $15,000, but that he also will be purchasing a new home in 2001 and plans on making a large down payment (with the sale proceeds from his prior residence) of $45,000. Pastor N’s spouse is employed as a college professor, and the couple plans on using her salary for living expenses in 2001. The church board is uncomfortable designating the entire salary as a housing allowance. According to the Tax Court’s recent decision, the board is free to designate all Pastor N’s compensation as a housing allowance.
4. Amending an existing housing allowance. The Tax Court’s decision suggests that church treasurers review the housing allowances designated for any pastor or pastors on staff. Churches are free to “amend” a housing allowance during the year if it proves to be inadequate to cover actual housing expenses. Of course, any amendment only operates prospectively and not retroactively. Here are some situations in which a church may want to amend a pastor’s year 2000 housing allowance as a result of the Tax Court’s decision.
- Percentage designations. Some churches designate a fixed percentage (e.g., 40%) of the compensation of pastors who own their home as a housing allowance, assuming that such an approach prevents the housing allowance from exceeding the annual rental value of the pastor’s home. The Tax Court’s decision makes percentage designations harder to justify, since they often will prevent pastors from having all of their housing expenses covered by their housing allowance.
- Basing housing allowances on annual rental value. Some churches are uncomfortable in designating a housing allowance in an amount significantly higher than the apparent annual rental value of a pastor’s home, since they assume that the nontaxable portion of the housing allowance cannot exceed this amount. There no longer is any justification for this approach. If your pastor’s housing allowance was based in part on the annual rental value of his or her home, then you should consider amending the allowance for the remainder of the year.
- “Accountable” arrangements. Some churches have adopted an “accountable” approach to handling housing allowances. Under such an approach, churches do not issue W-2 forms to pastors until the pastors provide the church treasurer with their actual housing expenses for the previous year. This allows the church treasurer to reduce a pastor’s W-2 income by the actual amount of the church-designated housing allowance that is nontaxable. In the past, such churches reduced W-2 income for pastors who own their homes by the lowest of the following three amounts: (1) the church-designated housing allowance; (2) the pastor’s substantiated housing expenses for the previous year; or (3) the annual rental value of the pastor’s home (furnished, including utilities). Such churches should now eliminate the annual rental value test in computing the nontaxable amount of the housing allowance.
- Change in circumstances. A number of circumstances may occur during the year that make an amendment to a pastor’s housing allowance appropriate. The Tax Court’s recent ruling allows churches to increase the portion of a pastor’s salary allocated to housing allowance no matter how significant those expenses may be. Here are some examples of circumstances that warrant a review of a pastor’s housing allowance: (1) a pastor purchases a new home; (2) a pastor incurs unexpected home repairs; (3) a pastor incurs remodeling expenses; (4) the purchase of new furnishings or appliances; (5) the mortgage interest rate under an adjustable rate mortgage on the pastor’s home is increased; (6) a pastor makes a large down payment on the purchase of a new home; or (7) a pastor makes a large prepayment of a mortgage loan.
5. Amended tax returns. Church treasurers should remind pastors that may file an amended tax return with the IRS (Form 1040X) if their nontaxable housing allowance was reduced in any one or more the previous three years because of the annual rental value test.
6. Get ready for 2001. In designating housing allowances for 2001, church leaders should take the Tax Court’s recent ruling into account. This means that you will not want to apply the “annual rental value test” in designating a housing allowance. For pastors who own their homes, the housing allowance may be any portion of their church compensation that is necessary to cover anticipated housing expenses.
7. Social security. Note that a housing allowance is nontaxable only in computing federal income taxes. Housing allowances are included in a pastor’s income in computing the self-employment (social security) tax. The same is true for the annual rental value of a church-provided parsonage. Be sure your pastor is aware of this important limitation.