EXECUTIVE
SUMMARY |
FOR CLERICS, GROSS INCOME
does not include housing
allowances paid as part of compensation to
the extent the allowance is used to rent
or provide a home and does not exceed the
fair rental value of the home plus the
cost of utilities. However, housing
allowances are included in income for
self-employment tax purposes.
TO QUALIFY FOR SPECIAL
TAX TREATMENT, clergy must
perform services in the exercise of
their profession and be duly ordained,
commissioned or licensed.
THE DETERMINATION OF
WHETHER A CLERIC is an
employee or self-employed for federal
income tax purposes primarily is based
on fact.
BUSINESS EXPENSES FOR
TRAVEL to visit hospitals and
nursing homes or to attend religious
conferences and meetings are allowable,
but deductions for a home office rarely
are allowed.
FEES PAID DIRECTLY TO THE
CLERGY FOR BAPTISMS, bar
mitzvahs, weddings and funerals are
includable in income on schedule C as
self-employment income even if the
cleric is considered an employee.
MINISTERS ARE
SELF-EMPLOYED FOR SOCIAL SECURITY
purposes even if they are
treated as employees for federal income
taxes.
COMMON TYPES OF
RETIREMENT PLANS AVAILABLE
for employee clergy include
IRAs, tax-sheltered annuities, qualified
pension plans, 401(k) plans, SEPs and
Rabbi trusts. | FRANCES E. McNAIR, CPA, PhD,
is a professor of accounting at
Mississippi State University. Her e-mail
address is
fmcnair@cobilan.msstate.edu . EDWARD
E. MILAM, CPA, PhD, is a professor of
accounting at Mississippi State University
in Starkville. His e-mail address is emilam@cobilan.msstate.edu
. DEBORAH SEIFERT, CPA, is a doctoral
student at Washington State University in
Pullman. Her e-mail address is dseifert@mail.wsu.edu
. |
ith today’s complex and
ever-changing rules, annual tax planning is
increasingly important for all taxpayers. However,
it’s especially important for members of the
clergy because of three unique rules that apply to
the income and Social Security taxes they pay: the
housing exemption allowance, the treatment of
employee clergy as self-employed for Social
Security tax purposes and the exemption from
withholding income tax from wages (but not from
paying income tax on wages). This article
discusses tax-planning opportunities for clergy
that CPAs in public practice need to know to best
counsel this special group of clients.
HOUSING EXEMPTION ALLOWANCE
A housing allowance is an
important tax benefit for clergy because it can be
excluded, within limits, from gross income for
federal tax purposes. It provides a way for many
religions to supplement, tax-free, the usually low
salaries they pay their clergy. Continuing this
tax-free status has strong bipartisan support, and
in 2002 Congress passed legislation aimed at
settling the issue of what amount can be excluded
from gross income. IRC section 107, as
amended by The Clergy Housing Allowance
Clarification Act of 2002, states that “in the
case of ministers…, gross income does not include
the rental allowance paid to him as part of
compensation to the extent used by him to rent or
provide a home and to the extent such allowance
does not exceed the fair rental value of the home,
including furnishings and appurtenances such as a
garage, plus the cost of utilities.” The housing
allowance must actually be used to maintain or
provide a furnished home and cannot be used for
other purposes.
Housing Allowance for Clergy
Without the housing allowance
they currently receive, America’s
clergy face a devastating tax increase
of $2.3 billion over the next five
years. Source: Rep.
Jim Ramstad (R, Minnesota), 148
Congressional Record H1300, April 16,
2002.
| In addition
IRS Publication 17, Your Federal Income Tax,
states that clerics who own their homes can
exclude the lesser of the following:
The amount actually used to provide a
home.
The amount designated as a rental
allowance.
The annual rental value of the home,
including furnishings. For clerics who own
their own homes, actual expenses include mortgage
interest payments, down payments, real property
taxes, insurance, utilities, furnishings, repairs
and improvements. The limitation on the
excludability of the clergy housing allowance
generally is effective for taxable years after
December 31, 2001. A cleric can receive a
housing allowance for only one home, and the
cleric’s church, temple or mosque must actually
designate, in advance, payments made for housing
or utilities as housing allowances so there is no
question these payments are excludable from gross
income. Ministers living in church-provided
parsonages, for example, do not have to include
the fair rental value of their homes in their
gross income and may exclude a designated
allowance for utilities and upkeep to the extent
of actual expenses. According to revenue ruling
87-32, those who receive a housing allowance still
are allowed to deduct mortgage interest and
property taxes on their federal tax returns as
itemized deductions. The Clergy Housing
Allowance Clarification Act applies only to
housing allowances and parsonage allowances for
federal income tax purposes. Housing and parsonage
allowances have always been, and continue to be,
included in income for self-employment taxes. In
addition, since the housing allowance is a part of
total compensation, religious organizations must
be careful to avoid paying their clerics
“unreasonable compensation,” which could
jeopardize their tax-exempt status. While there is
little guidance on what is considered reasonable,
CPAs should recommend that compensation packages
above $125,000 be reviewed by the board or
documentation for support be provided.
DETERMINING FAIR RENTAL VALUE
Since clergy housing
allowances are excludable only up to the maximum
of fair rental value, the determination of what
that constitutes is of utmost importance. Figuring
the fair rental value of a property would be
simple if there were fixed formulas, rules or
methods. Usually, there is no single formula that
applies when determining fair rental value. The
fair rental value usually is figured by examining
the facts and circumstances of each instance, but
in all cases should be based on a furnished
property plus utilities. The fair rental value of
a furnished property as a whole should be used,
not the fair rental value of a property plus the
fair rental value of the furniture. The
courts have allowed two methods for figuring fair
rental value. Both assume that fair rental value
is determined at arm’s length, that is,
objectively and between unrelated parties. The
primary method has been comparable fair rental
value based on the testimony of an expert
who compares the property in question with other
similar properties. CPAs can regard reliable real
estate agents as experts, able to quote rental
values based upon the location, size and condition
of the dwelling. The second valuation
method allowed by the courts is the comparable
sales method. This technique requires the
determination of two amounts: the fair market
value of the subject property and the rate of
return on investment that an unrelated lessor of
comparable property would require. The two numbers
are multiplied to determine the fair rental value
amount. The first amount, fair market value,
should be readily available from real estate sales
records. The second figure, the required rate of
return, is more subjective. The Tax Court used 13%
in the 1999 Hunt & Sons (66 TCM 853)
case, but a higher rate of return may be
justified. A required rate of 15% probably would
not be unreasonable.
WHO QUALIFIES?
It is common to think
that all members of the clergy are eligible for
special tax treatment, but this is not true. IRS
Publication 1828, Tax Guide for Churches,
broadly defines ministers as “members of
clergy of all religions and denominations and
includes priests, rabbis, imams and similar
members of clergy.” But, according to Treasury
regulations section 1.1402(c)-5, in order to
qualify for special tax treatment as clergy, an
individual must be a “minister” performing
services “in the exercise of his ministry” and a
“duly ordained, commissioned or licensed minister
of a church.” The services performed by a minister
in the exercise of the ministry include the
“ministration of sacerdotal functions,” the
“conduct of religious worship” and the “control,
conduct and maintenance of religious organizations
(including religious boards, societies and other
church or church denomination).” In each
case the facts determine whether an individual is
duly ordained, commissioned or licensed, since
religious disciplines vary in their formal
procedures in these areas. For example, the Tax
Court in Salkov (57 TC 727) found that a
Jewish cantor who wasn’t ordained but who had a
bona fide commission and who was employed by a
congregation on a full-time basis was a minister
for tax purposes because he performed the
religious worship, sacerdotal, training and
educational function as specified by Jewish
religious tenets. However, in Lawrence
(50 TC 494) the Tax Court found that a
minister of education in a Baptist church didn’t
qualify for special tax treatment because he was
commissioned but not ordained and wasn’t able to
officiate at baptisms or the Lord’s Supper or to
preside over or preach at worship services. Youth
ministers, ministers of education or other
special-function ministers may find themselves in
this same situation. CPAs must take into account
the duties of clerics with regard to sacraments
and worship when making the determination of
whether they qualify as “ministers of the gospel.”
EMPLOYEES OR SELF-EMPLOYED?
The determination of
whether a cleric is an employee or self-employed
for federal income tax purposes is based primarily
on fact. Most probably are employees under the
current tests used by the IRS and the courts. From
a tax-planning standpoint, they generally are
better off being classified as employees than as
self-employed persons for several reasons. First,
classification as an employee allows the value of
various fringe benefits available to
employees—such as employer-paid health insurance
premiums, life insurance premiums and
contributions to retirement plans—to be excluded
from income. Second, as employees, most clerics
can be reimbursed by their organization for
business expenses without any income tax
consequences as long as the reimbursement is
through an “accountable plan.” Reimbursements
under an accountable plan are especially
beneficial to clerics subject to the alternative
minimum tax (AMT). The amount of the reimbursement
is not included in income and there is no AMT
adjustment for the related expenses since they are
not deducted as miscellaneous itemized deductions.
Finally, clerics are less likely to trigger an IRS
audit with employee status. According to a GAO
report in 2001, audit risk is much higher for
self-employed persons than for employees.
The downside of being considered an employee
for federal income tax purposes is that
unreimbursed employee business expenses are
subject to a 2% of adjusted gross income (AGI)
floor and must be reported on schedule A. Clerics
who do not itemize thus will lose any deduction
for unreimbursed employee business expenses.
Generally, someone is an employee if the
employer has the legal right to control both what
the individual does and how the work is performed.
However, there are a few situations in which a
cleric is more likely to be classified as
self-employed rather than as an employee for
federal income tax purposes. For example,
itinerant evangelists usually conduct services in
several different churches during the course of a
year and ordinarily are self-employed. Guest
speakers also are usually self-employed as are
ministers on temporary assignment to a church.
Clerics who are employees may be self-employed for
certain services such as baptisms, bar mitzvahs,
weddings and funerals. These services usually are
performed directly for church or temple members
who pay a fee to the cleric. Members of
the clergy who work without direct control and
supervision may think they are self-employed.
However, the Tax Court in James (25 TC
1296) stated that “despite this absence of direct
control over the manner in which professional men
and women shall conduct their professional
activities, it cannot be doubted that many
professional men and women are employees.”
Whether they are classified as employees or as
self-employed for federal income tax purposes,
clerics are exempt from federal tax withholding.
However, those who are classified as employees can
request that their income taxes and
self-employment taxes be withheld from their
salary payments, and CPAs should advise them to do
so. If they don’t, members of the clergy must make
quarterly estimated payments for federal income
taxes and self-employment taxes to avoid penalties
for underpayment of taxes. RESOURCES
| Church & Clergy Tax
Guide by R. Hammer, 2004 edition,
Christian Ministry Resources, Matthews,
North Carolina, 2003.
www.clergysupport.com provides
some free useful information.
IRS Audit Guide,
Ministers: Market Segment
Specialization Program.
IRS Publication 533,
Self-Employment Tax.
IRS Publication 517,
Social Security and Other
Information for Members of the Clergy
and Other Religious Workers.
IRS Publication 1828,
Tax Guide for Churches.
IRS Publication 17,
Your Federal Income Tax.
All IRS publications can be found at
www.irs.gov .
|
CLERGY BUSINESS EXPENSES
Clerics who are
classified as employees may be reimbursed for
business expenses such as meals, travel, office
supplies, and robes and vestments. However, for
the reimbursement to be excluded from income, it
must be made under an accountable plan, that is,
an arrangement that requires a business purpose
for all reimbursements, substantiation within a
reasonable period of time and reimbursement of any
payments in excess of substantiated business
expenses to the employer within a reasonable
period of time. Business expenses that are
not reimbursed under an accountable plan or that
are in excess of the amounts allowed under such
plans are deductible on form 2106 for employees
and on schedule C for self-employed taxpayers. A
common business expense for clergy is travel;
deductions can be taken for trips to hospitals or
nursing homes, conferences and meetings in town or
out of town, and any other business-related
travel. Clergy face the same deductibility
limitations on travel, meals, entertainment and
lodging as do other taxpayers. Travel to and from
their houses of worship, for example, is
considered a commuting expense and is
nondeductible. Clergy also may have other
deductible business expenses related to their
profession. Purchasing supplies or paying renewal
fees for maintaining credentials are valid
deductible business expenses, as are telephone
expenses for business purposes and deductions for
special robes or vestments. If a cleric is an
employee, reimbursements under nonaccountable
plans must be reported as income. Business
expenses then are deductible as miscellaneous
itemized deductions subject to the 2% of AGI
floor. These expenses generally are reported on
form 2106, or for self-employed ministers, on
schedule C. Regardless of whether a cleric
is an employee and deducting business expenses on
form 2106 or self-employed and deducting business
expenses on schedule C, some percentage of
business expenses will not be deductible in most
cases. If a cleric’s compensation includes a
parsonage or housing allowance, which is
excludable from gross income, the nondeductible
business expense percentage is based on the ratio
of the clergy’s nontaxable to taxable income. CPAs
can find detailed examples and worksheets in IRS
Publication 517, Social Security and Other
Information for Members of the Clergy and Other
Religious Workers. Not all expenses
are deductible, though. Deductions for a home
office rarely are allowed since churches and
temples usually provide an office, and parsonage
allowances already are excluded from income.
Contributions made by clerics to their
congregations also are not classified as business
expenses but are deductible as itemized charitable
deductions on schedule A. Business suits aren’t
deductible since they can be worn outside of work,
and dry-cleaning expenses also can’t be deducted.
GIFTS AND COMPENSATION
Many clerics
mistakenly believe that special offerings or
bonuses they receive are gifts when in fact the
IRS views these as compensation for services
rendered. The definition of a gift for tax
purposes is “proceeding from a detached and
disinterested generosity…out of affection,
respect, admiration, charity or like impulses. The
most critical consideration…is the transferor’s
intention.” Therefore, gross income for clergy
includes compensation, bonuses and “special gifts”
that have been made out to the church, temple or
mosque and then given to the cleric, or for which
a parishioner or member is taking a charitable
deduction. It also includes expense allowances for
travel, transportation or other business expenses
received under a nonaccountable plan and amounts
paid to cover a cleric’s self-employment or income
taxes. Payments made for spousal travel are
taxable as income unless the spouse was required
to travel for religious business purposes.
Fees paid directly to the cleric for performing
ceremonies such as weddings, bar mitzvahs,
funerals, baptisms and masses all are includable
in income on schedule C as self-employment income
even if the cleric is an employee. Fees given
directly to the congregation rather than to the
cleric aren’t considered compensation to the
cleric unless the congregation then writes a check
out to him or her. Contributions made to or for
the support of individual missionaries are
includable as gross income to the missionaries.
SELF-EMPLOYMENT TAXES FOR CLERGY
Members of the clergy
always are self-employed for Social Security
purposes even if they are treated as employees for
federal income tax purposes. Thus, a cleric pays
12.4% for Social Security on income up to $87,900
for 2004 and 2.9% for Medicare on all
self-employment income just like everyone else.
Earnings for self-employment taxes include the
total compensation such as salary and any
parsonage or housing allowance reduced by business
expenses, whether unreimbursed or reimbursed under
a nonaccountable plan. In addition, one-half of
the self-employment tax (computed without regard
to this deduction) can be deducted in computing
net earnings from self-employment. Also, half of
an individual’s self-employment tax is deductible
in arriving at adjusted gross income when
computing federal income taxes. Clerics
may file for an exemption from self-employment tax
under certain circumstances. For example, those
who conscientiously object to, or whose religious
principles oppose, the acceptance of public
insurance (for example, benefits established by
the Social Security Act) may file for an exemption
under section 1402(e)(1). However, the exemption
is valid only if approved by the IRS. CPAs can
find the requirements for the exemption in IRS
Publication 517.
|
PRACTICAL TIPS TO
REMEMBER
| |
When advising members of
the clergy, CPAs should
Recommend that
compensation packages above
$125,000 be reviewed by the
board and that documentation
be reviewed to make sure
compensation is reasonable.
Check out revised
IRS Publication 1828, Tax
Guide for Churches, for
some limited guidance on who
is a minister. While the issue
is critical, the IRS has
provided little other advice
on the subject.
Consider
classifying clergy as
employees rather than
self-employed to take
advantage of nontaxable fringe
benefits such as health
insurance, life insurance,
employer-provided retirement
plans and a lower IRS audit
risk.
Advise the
church, temple or mosque to
adopt an accountable
reimbursement arrangement if
an accountable plan is used
for business expenses. Be sure
the cleric has sufficient
evidence to substantiate the
amount, date, place and
business purpose of the
expense.
Remind clerics
that “love offerings,” bonuses
and other gifts are taxable
income.
Encourage
organizations that offer
“denominational plans” to
designate that a part of the
benefit be used as housing
allowance, which will be
excluded from both income tax
and self-employment taxes of
the cleric in retirement.
| |
CLERGY RETIREMENT PLANS
A number of
tax-favored retirement plans available to clergy
include the same types that are available to all
employees, as well as some unique plans and
features. Common types of retirement plans include
individual retirement accounts (both Roth and
regular), tax-sheltered annuities (403(b) plans),
qualified pension plans, 401(k) plans, simplified
employee plans (SEPs) and “Rabbi trusts.”
Self-employed clergy also may establish Keogh
plans. One unique plan for clergy whose
features CPAs should be aware of is the “Rabbi
trust” arrangement, which allows a religious
organization to transfer assets into a trust whose
income and principal will be paid to the clergy
upon retirement. IRS letter ruling 8113107
concluded that the transfer of the assets into
such a trust didn’t cause a taxable transaction
for the beneficiary. If the guidance provided in
revenue procedure 92-64 is followed, this is an
effective way for CPAs to defer the taxation on
the transfer of assets until they actually are
paid to the beneficiary. Denominational
plans or retirement plans such as 403(b)s or SEPs
established by religious denominations for their
clerics also offer significant opportunities.
These plans can be funded by the employing
organization, but even if they are completely
funded by the cleric, they provide attractive
benefits that aren’t available with other
retirement plans. The significant benefit of such
plans is that taxpayers can declare that a part of
the benefit is for a housing allowance for the
retired cleric, thereby sheltering a portion of
the retirement benefits from taxation. In addition
Congress in 1996 excluded the parsonage allowance
from self-employment taxes after the cleric
retires, making denominational plans especially
attractive.
CLERGY’S UNIQUE TAX ISSUES
Members of the clergy
face a wide variety of tax complexities and can
benefit greatly from expert tax advice in the
areas of housing exemption allowance, employee vs.
self-employed status, business expenses,
self-employment taxes, gifts and compensation and
retirement plan options. Sound tax planning advice
can help them reap the tax benefits afforded their
profession under the Internal Revenue Code. |