«Top 10 Questions that Pastors (and Church Treasurers) Ask Tax Preparers (Created May 2007) Based on my experience, following are frequent questions ...»
Top 10 Questions that Pastors (and Church Treasurers)
Ask Tax Preparers (Created May 2007)
Based on my experience, following are frequent questions asked by pastors, church treasurers, and others
serving in ministry positions as licensed or ordained ministers. My answers are not intended to be exhaustive.
Accordingly, you must consult your own tax professional for assistance in applying this information to your
specific tax situation
—Corey A. Pfaffe, CPA, PhD, www.MinistryCPA.org, firstname.lastname@example.org, (920) 261-7012.
1. Am I an employee of the church or am I self-employed?
The answer is “both.” Most ministers are considered employees in every respect except for purposes of paying self-employment tax (Medicare and Social Security). This means that they are eligible for virtually all employee benefits that are given favorable tax treatment in the IRC. Many of these benefits are unavailable to the typical self-employed individual.
Ministers who have not opted out of the Medicare and social security system, however, are not permitted to have FICA withheld and matched by the church. They must pay the entire
15.3 percent self-employment tax. Many churches provide additional funds to assist their pastors in the payment this tax, but this additional compensation, while very helpful, is itself subject to both income and self-employment tax.
Itinerate evangelists are a common example of ministers who do not have employee status;
they are entirely self-employed.
2. What can I deduct for a housing/parsonage allowance?
A minister who receives a housing allowance may exclude the allowance from gross income to the extent it is used to pay expenses in providing a home. A minister living in a parsonage qualifies for a housing allowance to the extent of his own out-of-pocket costs. The minister’s church or other qualified organization must designate the housing allowance pursuant to official action taken in advance of the payment. The IRS lists only food and servants as prohibitions to allowable housing expenses. If a minister owns a home, the amount excluded from the minister’s gross income as a housing allowance is limited to the least of the
following three amounts:
(a) The amount actually used to provide a home.
(b) The amount officially designated as a housing allowance.
(c) The fair rental value of the home.
ALLOWABLE HOUSING EXPENDITURES Total mortgage payments (Be careful not to duplicate amounts included below under “real estate taxes” and “homeowner’s insurance”) Real estate taxes Homeowner’s or renter's insurance Furniture, furnishings, appliances Utilities (including heat, lights, water, sewer, telephone, water softener, cable, waste disposal, etc.) Top 10 Questions that Pastors Ask Tax Preparers, Page 2 Rent paid Repairs paid personally Loan refinancing costs Other (everything except food and household employee compensation) (Sources: IRS Publication 1828; Clergy Housing Allowance Clarification Act of 2002; IRS Regulation §1.107-1) Tax-saving opportunity: Beginning with the 2002 tax year, the calculation of the federal Earned Income Credit excludes the housing allowance as earned income for ministers who have opted out of
the Social Security system; accordingly, many more ministers are now eligible for the credit (sources:
IRS Publication 596; Internal Revenue Code (IRC) §32(c)(2)(A)(i)).
3. What are my retirement plan options and what are the advantages / disadvantages of each?
The best retirement plan option for each minister depends on his objectives and his current
tax situation. The three most common retirement plan options used by ministers include:
(a) IRC 403(b) plans (also called Tax Sheltered Annuities (TSAs)), (b) Traditional Individual Retirement Accounts (IRAs), and (c) Roth IRAs.
Ministers often select 403(b) plans when they want to maximize their eligible contributions, or to reduce their self-employment tax burden. For the year 2007, a minister may elect to have his employer withhold (“elective deferral”) up to $15,500 of his compensation and contribute it, instead, to his 403(b) qualified investment account. Many ministers are eligible to increase this amount by another $5,000 to catch-up for earlier years’ smaller deferrals (source: IRS Publication 571). In addition, unlike other retirement plan choices, a minister is not subject to the 15.3 percent federal self-employment tax on amounts deferred into 403(b) accounts (source: IRS Revenue Rulings 68-395 and 78-6). This is also true of any amount that his employer contributes over-and-above the minister’s own elective deferral.
The situations for which Traditional IRAs are the best choice for a minister’s retirement plan are less frequent, especially since the establishment of Roth IRAs beginning with the 1998 tax year. For the year 2007, a minister and his wife may each contribute up to $4,000 to qualified IRA accounts; an additional $1,000 each may be contributed if they are 50 years of age. A minister who has opted out of the social security system but is still looking for additional income tax deductions may find the Traditional IRA his best choice. These contributions can often by made even if the minister participates in a 403(b). However, he may not be able to deduct his full Traditional IRA contribution. For this reason and others, many ministers choose Roth IRA’s instead of Traditional IRAs.
Roth IRAs enable ministers to make the same amount of contributions as do Traditional IRAs but without receiving an income tax deduction. For many ministers, especially those with young families and ample housing allowances, additional tax write-offs are not needed.
Unlike Traditional IRAs, not only will future retirement (age 59½ or later) distributions of Top 10 Questions that Pastors Ask Tax Preparers, Page 3 their current contributions be untaxed, the earnings distributed from the Roth IRA will not be
taxed. Further, pre-retirement distributions may be made without penalty for:
(a) Medical expenses (and health insurance premiums for the unemployed).* (b) Qualified higher education expenses.* (c) New home purchase costs for taxpayers who have not owned a personal residence for at least two years (“first time homebuyers”).
*Also available for some Traditional IRA distributions.
Tax-saving opportunity: Beginning with the 2001 tax year (scheduled to terminate after 2007), many ministers who participate in retirement plans have also reduced their federal income tax by taking advantage of the retirement savings contributions credit. The credit is equal to 50% of Traditional and Roth IRA and 403(b) plan contributions for married filing joint taxpayers with Adjusted Gross Income less than $30,000. Reduced credits are available for those with AGI greater than $30,000 but less than $50,000 (IRS Form 8880). With housing allowances reducing their AGI to these levels, many pastors are eligible.
4. Do you think I should suggest that the church set up a car allowance?
Any financial assistance that a minister’s employer can give is appreciated. A car allowance can be especially helpful. Car allowances, however, must be established as “accountable plans.” This means that any advances given by the employer to the minister must be properly substantiated on a timely basis or the law requires the minister to refund the unspent, undocumented portion of the allowance.
It’s a better idea to offer a professional expense allowance (instead of a car allowance) that covers car expenses and any other professional expense. Documentation can then include non-auto costs such as air travel, lodging, conferences, gifts, entertainment, books, supplies, and any other legitimate ministry-related expenditure. The minister documents car expenses when he provides a record of the date, business purpose, and number of miles for each trip.
The total miles submitted for reimbursement should then be multiplied by a per mile rate adopted by the church. The IRS sets maximum per mile rates each year that may be used if the church wishes without requiring inclusion of the reimbursement payments on the minister’s annual Form W-2.
Even though the IRC permits the payment of advances, church funds will more be managed more effectively if the church budget establishes an expense category with an annual limit and if the church only disburses funds as documentation is received.
Tax-saving opportunity: For 2007, the IRS increased the allowable mileage reimbursement/deductibility rate to 48.5 cents per mile.
Tax-saving opportunity: Ministers who incur unreimbursed employee business expenses may include these costs as miscellaneous itemized deductions on Schedule A. Unfortunately, these deductions often do not reduce ministers’ taxable income because of required modifications for two percent of Adjusted Gross Income and for the prorated tax-free portion of their income (i.e., the housing allowance) (source: Publication 517). However, many ministers fail to also reduce their self-employment taxable income on Schedule SE by these same amounts.
5. What reports does the church need to file with the government regarding my compensation?
Top 10 Questions that Pastors Ask Tax Preparers, Page 4 Other than compensation to its pastor, a church files the same reports and is subject to the same withholding rules as any other organization. The only exceptions relate to the exemption from unemployment taxes that all churches enjoy and to an exemption from FICA tax that a few churches applied for in the 1980s. IRS Publication 15 can answer treasurers’ standard questions regarding church payroll.
6. Do you have any ideas that the church can consider to control its rising health care costs?
Many ministers and their employers are looking for alternative plans to control rising health care costs without neglecting those in need of medical services. Many churches have only one employee—the pastor. This offers greater flexibility in crafting a plan based on purchasing major medical health insurance for catastrophic needs and self-insuring for all other health costs. The benefit to ministers is that self-insurance offers an opportunity to cover dental, vision, and other medical needs that are excluded from typical health insurance plans. IRS Notice 2002-45 announced creation of a new employer-provided plan—a health reimbursement arrangement (HRA)—that permits “reimbursements of medical expenses of an employee (or former employee) and the employee's spouse and dependents [that] are generally excludable from the employee's income... This is true even if the HRA allows unused amounts to be carried forward. According to the Notice, an HRA is an arrangement
Top 10 Questions that Pastors Ask Tax Preparers, Page 5 (1) Is paid solely by the employer.
(2) Reimburses the employee for medical care expenses incurred by the employee and the employee's spouse and dependents.
(3) Provides reimbursements up to a maximum dollar amount for a coverage period, and provides that any unused portion of the maximum dollar amount at the end of a coverage period is carried forward to increase the maximum reimbursement amount in later coverage periods.
Any medical expense that qualifies for a tax deduction on an individual’s Form 1040, Schedule A qualifies (source: IRC §105-106). The church is required to maintain substantiation for all reimbursements. An HRA is subject to non-discrimination rules; this means that “highly compensated individuals” cannot receive benefits not equitably offered to other employees. However, churches with only one employee do not have these potential constraints.
7. Can a church give non-taxable gifts to its minister?
Any gifts paid by employers to their employees are considered taxable income and must be reported together with other earnings on Forms 941 and W-2. The only exception relates to gifts of tangible personal property valued less than $25. Accordingly, the typical Christmas bonus collection received by many congregations and given to their employees represent fully taxable compensation. Of course, as participants in a church-sponsored collection, donors may write off their contributions as tax-deductible donations. On the other hand, personal gifts from a member to a minister are neither taxable to the minister, nor deductible by the member.
8. How can the church and I work together to sell the parsonage and to get my family into a home of our own?
The answer to this question varies greatly based on the church’s and pastor’s specific situation. However, following are several issues that most likely will need to be addressed.
(a) Any property transferred by the church to the pastor will be considered taxable compensation at its fair market value (reduced by any payment by the pastor to the church).
(b) Because the pastor will no longer be living in real estate that is tax-exempt housing, his costs of living will increase accordingly.
(c) The tax-free nature of a housing allowance may not fully eliminate the taxability of any one-time, large bonuses to the minister, even if entirely disbursed to construct or purchase a home. This is due the requirement that a housing allowance not exceed the annual fair rental value of a minister’s housing.
(d) Interest-free (or below market rate) loans from the employer to the minister or principal forgiveness arrangements in reward for ongoing longevity can aid in the transition from a church’s “parsonage era” to homeownership for its pastor. Care must be taken, however, to comply with IRS income reporting rules and to establish a written agreement that reflects the true substance of a legally binding arrangement between the church and its pastor.
Tax-saving opportunity: December and January “bonuses” to assist the minister in constructing or purchasing a home, if implemented properly, can spread the income and self-employment tax costs Top 10 Questions that Pastors Ask Tax Preparers, Page 6 over two different tax years. Principal forgiveness arrangements established as legitimate compensation for ongoing longevity can spread these tax costs over several consecutive years.
9. Should I “opt out” of the social security system?