Ministers and treasurers must be familiar with the tax rules that apply to clergy. Unfortunately, seminary training rarely equips new ministers with this information, and church treasurers often don't know about the unique tax laws that apply to clergy. This information gap means ministers and treasurers frequently handle clergy income and the payment of related taxes incorrectly, and they fail to take advantage of the tax benefits that are available to ministers.
For instance, ministers are eligible for five special tax rules with respect to services they perform in the exercise of their ministry. These include (1) not paying federal income taxes on the portion of their church compensation designated in advance by their church as a housing allowance (limitations apply), (2) not paying federal income taxes on the annual rental value of a parsonage provided by their church, (3) being exempt from "self-employment taxes" (Social Security taxes paid by the self-employed) if several conditions are met, (4) being considered self-employed for Social Security (if not exempt), and (5) having ministers' wages exempt from income tax withholding.
In order to qualify for these tax savings, however, you must meet the IRS's definition of a "minister." The IRS applies a five-factor test to determine whether an individual qualifies as a minister for federal income tax purposes. In general, for individuals to enjoy the five special tax rules summarized above, they must satisfy two main requirements: they must be a minister, and they must be engaged in the exercise of ministry.
Assuming you clear these IRS hurdles for establishing whether or not you're a minister for federal tax purposes, you then need to know how to file taxes properly to ensure you receive the benefits available to you.
In this article, we focus on three of the most perennially perplexing tax issues for clergy. While there are many more we could cover, these are the three that pose confusion and uncertainty for many ministers and church treasurers, new and seasoned.
1. Should a Minister Report Income Taxes as an Employee or as Self-Employed?
The question of whether ministers should report their federal income taxes as an employee or as self-employed is a significant one. Most new ministers should report their federal income taxes as employees, because they will be considered employees under the tests currently used by the IRS and the courts. Most clergy will be "better off" reporting as employees, since (1) the value of various fringe benefits will be excludable, including the cost of employer-paid health insurance premiums on the life of the minister, (2) the risk of an IRS audit is substantially lower, and (3) reporting as an employee avoids the additional taxes and penalties that often apply to self-employed clergy who are audited by the IRS and reclassified as employees.
2. Should a Minister Report Social Security Taxes as an Employee or as Self-Employed?
There is one provision in the tax code that has caused more confusion for ministers and church treasurers than any other, and it is this: ministers are always treated as self-employed for Social Security with regard to services they perform in the exercise of their ministry (except for some chaplains). This is true even if they are employees for federal income tax reporting. This is sometimes referred to as the "dual tax status" of ministers.
Many new (and even veteran) ministers are surprised to learn that their employment status for income tax purposes has no bearing on their employment status for Social Security taxes. This often creates confusion. Ministers are always self-employed for Social Security with respect to their ministerial services. This is true even if you are treated as an employee for federal income tax purposes. This means you pay the self-employment tax, not "Social Security" and "Medicare" taxes. Your employing church must not treat you as an employee for Social Security, even though it issues you a W-2 for income taxes.
The most important consequence of this dual tax status is that ministers pay the so-called "self-employment tax." This is the Social Security tax that is paid by self-employed workers. It amounts to 15.3 percent of a minister's taxable earnings. Employees and employers pay "Social Security" and "Medicare" taxes (sometimes collectively referred to as "FICA" taxes). Like self-employment taxes, these taxes amount to 15.3 percent of a minister's taxable earnings. But there is a big difference. Employers and employees split the 15.3 percent tax rate, with each paying 7.65 percent. Self-employed persons pay the entire self-employment tax. Many churches pay half, or even all, of a minister's self-employment tax. This is perfectly appropriate, but any amount paid by the church must be reported as taxable income to the minister.
3. How Does a Minister Pay Taxes?
Many churches erroneously withhold the employee's share of Social Security and Medicare taxes from ministers' compensation, and then pay the employer's share. In other words, they treat their minister as an employee for Social Security. This is understandable, especially when the church treats the minister as an employee for purposes of federal income taxation. But, it is always incorrect for a church to treat a minister as an employee for Social Security. Self-employment taxes for ministers are computed on Schedule SE of Form 1040.
The federal income tax is a "pay as you go" tax. This means that you must pay your tax as you earn income during the year. There are two ways to do this—quarterly estimated tax payments and tax withholding.
Ministers must prepay their income taxes and self-employment taxes using the estimated tax procedure, which can be confusing. Nonetheless, it's important to understand how to calculate and pay estimated taxes to avoid significant tax liabilities.
Generally, you should make estimated tax payments if your estimated tax for this year will be $1,000 or more and the total amount of income tax that will be withheld from your income will be less than the lesser of (1) 90 percent of your tax liability for the current year, or (2) 100 percent of your tax liability for the previous year (if it covered all 12 months of the year). If you are required to pay estimated taxes, but fail to do so, you will be subject to an "underpayment penalty." Since the penalty is figured separately for each quarterly period, you may owe a penalty for an earlier payment period even if you later paid enough to make up the underpayment. If you did not pay enough tax by the due date of each of the payment periods, you may owe a penalty even if you are due a refund when you file your income tax return!
The 4-step procedure for paying estimated taxes
Complying with the estimated tax procedure is easier than it seems. Here are the four steps you need to follow:
Step 1–Obtain a copy of IRS Form 1040-ES prior to April 15 of the current year.
Step 2–Compute estimated taxes.
Calculate your estimated tax for the current year by estimating adjusted gross income and then subtracting estimated adjustments, deductions, exemptions, and credits. Multiply estimated taxable income times the applicable tax rate contained in the Tax Rate Schedule reproduced on Form 1040-ES. Include your estimated Social Security tax on the worksheet if you are not exempt, and include your housing allowance exclusion in computing your estimated earnings subject to the self-employment tax.
Step 3–Pay estimated taxes in quarterly installments.
If estimated taxes (federal income taxes and self-employment taxes) are more than $1,000 for the current year, and the total amount of taxes to be withheld from your compensation is less than the lesser of (1) 90 percent of your tax liability for the current year, or (2) 100 percent of your tax liability for the previous year, then you must pay one-fourth of your total estimated taxes in four quarterly installments (by April 15 for January 1 to March 31; by June 15 for April 1 to May 31; by September 15 for June 1 to August 31; and by January 15 for September 1 to December 31). If the due date for making an estimated tax payment falls on a Saturday, Sunday, or legal holiday, the payment will be on time if you make it on the next business day.
Payment vouchers. You must send each payment to the IRS, accompanied by one of the four payment vouchers contained in Form 1040-ES.
Starting a job in mid-year. A minister who becomes liable for estimated tax payments midway through a year should submit a payment voucher by the next filing deadline accompanied by a check for a prorated portion of the entire estimated tax liability for the year.
Changing your quarterly payments. Changes in your income, deductions, credits, or exemptions may make it necessary for you to refigure your estimated tax and adjust your remaining quarterly payments accordingly.
Step 4–Compute actual taxes.
After the close of the year, compute your actual tax liability on Form 1040. Only then will you know your actual income, deductions, exclusions, and credits. Estimated tax payments rarely reflect actual tax liability. Most taxpayers' estimated tax payments are either more or less than actual taxes as computed on Form 1040 (usually less).
Overpayment. If you overpaid, you can elect to have the overpayment credited against your first quarterly estimated tax payment of the following year or spread out in any way you choose among any or all of your next four quarterly installments. Alternatively, you can request a refund of the overpayment.
Underpayment. If you underpaid your estimated taxes you may have to pay a penalty. The penalty is computed separately for each quarterly payment period. Contrary to popular belief, payment of your entire estimated tax liability with your Form 1040 will not relieve you of the penalty if you did not pay the estimated income tax due earlier in the year.
Form 2210. You can use Form 2210 to see if you owe a penalty and to figure the amount of the penalty. If you owe a penalty and do not attach Form 2210 to your Form 1040, the IRS will compute your penalty and send you a bill. You do not have to fill out a Form 2210 or pay any penalty if either of two conditions apply: (1) your total tax less income tax withheld is less than $1,000, or (2) you had no tax liability last year and you were a United States citizen or resident for the entire year. The IRS can waive the underpayment penalty if the underpayment was due to casualty, disaster, or other unusual circumstance and it would be inequitable to impose the penalty.
Special rule for high-income taxpayers. A high-income taxpayer with adjusted gross income for the previous year of at least $150,000 cannot avoid the underpayment penalty by paying estimated taxes for the current year of at least 100 percent of last year's tax. For such persons, the "100 percent rule" is replaced with a 110 percent rule, meaning that they will be subject to an underpayment penalty unless they have paid estimated taxes for the current year of at least the lesser of (1) 90 percent of the current year's actual tax liability, or (2) 110 percent of last year's actual tax liability.
Ministers who report their income taxes as an employee may request "voluntary withholding" of their income taxes and self-employment taxes by filing a Form W-4 with the church. A self-employed minister is free to enter into an "unofficial" withholding arrangement whereby the church withholds a portion of his or her compensation each week and deposits it in a church account, and then distributes the balance to the minister in advance of each quarterly estimated tax payment due date.