In January 1986, pastor Brad Thomas took the district superintendent to dinner at Denny’s prior to a church committee meeting. He carefully noted the purpose on the receipt he kept. When he next figured his taxes, he planned to deduct the amount of the meal from his taxable income. Since the church gave him an expense allowance, Brad was not spending personal income for church business, nor would he pay income tax on what amounted to a reimbursement for expenses the church intended him to incur. Thousands of pastors have operated this way for years.
If, in January 1987, Brad ate the same meal uniter the same circumstances and followed the same accounting procedure, he might not be able to deduct any of the expenses from his taxable income.
The Tax Reform Act of 1986 has made significant changes in the way many churches should compensate their pastors and in the way many pastors will figure their taxes, beginning in 1987.
In brief, if Brad continues with business as usual, he will pay more income taxes than would otherwise be required, and that means his take-home pay will be less than it could be.
As with most regulations, the Tax Reform Act of 1986 is both good news and bad news for pastors.
Good news for homeowners
Without a doubt, Section 107 of the Internal Revenue Code has for more than sixty years provided ordained clergy with one of the greatest tax benefits available. Qualifying clergy pay no income tax on the value of the parsonage they live in, nor, if they own their own home, do they pay on any allowance they receive, to the extent it is spent to provide for that home. (However, that value or allowance is fully taxable for social security tax purposes.) Clergy are also allowed to deduct mortgage interest and property tax expenses from the taxable portion of their income, thus reducing even further their income taxes.
At least they could until IRS Revenue Ruling 83-3 sought to repeal this double benefit in 1983. Although implementation of the ruling was repeatedly delayed for pastors maintaining the same residence, all clergy expected to lose this privilege beginning in 1987.
Here’s the good news: The 1986 Tax Reform Act once again permits all home-owning clergy to itemize as a deduction the mortgage interest and real estate taxes paid on their principal residence, even though the housing allowance was used to pay for that interest and tax expense. This returns pastors’ tax conditions to the pre-1983 days, which is good news to home-owning clergy.
And there’s more good news: the law is retroactive. Thus any clergy who did not deduct interest and property taxes in 1983, 1984, or 1985 because of the now-repealed ruling, may file an amended tax return (Form 1040X) and claim a refund, although it needs to be done before April 15, 1987 for the 1983 tax year. That means clergy who bought a home during this period and were excluded from the double benefit may now recover it.
Bad news about expense allowances
Most churches intend to reimburse their pastor for professional expenses-car, books, continuing education, business meals, conventions, subscriptions, pulpit garments. They write into the budget an allowance and pay it with the pastor’s salary. The IRS considers it income, but in the past, at tax time, the pastor consulted his records, knocked these expenses off his income on the tax return, and ended up not being taxed for professional expenses.
All this is changing.
Under the new tax law, churches and pastors following this procedure will fall into an unintentionally expensive tax trap. A simple new accounting system, however, will keep the tax bite off the pastor’s professional expenses.
The new law continues to provide that any professional expense allowance is fully taxable-the same as salary-reported on the minister’s W-2, and included on Form 1040. But now, expenses are not always or completely deductible. The new law provides, first, that only 80 percent of business meals and entertainment expenses are deductible. Second, 80 percent is deductible only when itemized on Schedule A, and then only to the extent that it (along with all other unreimbursed professional expenses) exceeds 2 percent of adjusted gross income.
Who loses? Everyone who uses the old system. They end up paying taxes on the 20 percent that is not deductible and on the portion of their allowance that makes up 2 percent of adjusted gross income. Worse, if they take the standard deduction and don’t itemize, they pay taxes on the whole allowance.
For example, let’s say Brad’s business meals total $1000, his other professional expenses are $2000, and his adjusted gross income (salary plus allowances) is $20,000. Assuming Brad itemizes deductions, in 1986 he would deduct all $3000 of expenses and pay taxes on $17,000. In 1987, however, he can deduct only $800 of the meals and entertainment expenses, thus paying taxes on the other $200. Brad will also pay taxes on the first $400 of expenses, since he can deduct only what is above that 2-percent figure. So in 1987, Brad will be taxed for $17,600, that is $20,000 ($800 + $2000 – $400).
If he is in the 15-percent tax brackets Brad will thus pay $90 more taxes in 1987, taxes on what the church intended as reimbursements, not income.
Let’s say Brad is in a parsonage and has few itemized deductions. Normally, he would be wise to take the standard deduction, which for joint filers in 1987 is $3,760 ($5000 in 1988). But then he can deduct none of his professional expenses. He’ll end up paying tax on all $3,000 of expenses, or $450 in the 15-percent bracket. Obviously, Brad’s church needs to change his method of reimbursement.
Fortunately, a simple remedy exists.
Reimbursements, not allowances
Since there is no way clergy will be able to deduct all their professional expenses, even if the congregation provides generous allowances, the best way for a congregation to maximize the pastor’s pay package is to provide reimbursement, not an allowance.
The procedure is simple. Brad fills out an expense report each month, gives it to the church treasurer, and then is reimbursed for that amount. Nothing more needs to be done for tax purposes-no reporting on a W-2, no deductions on Form 1040.
Rather than continuing to pay him an allowance with his pay, his church will reserve the $3,000 as a budget line item and dole it out monthly as reimbursement for specific expenses. This system costs the church no more, and Brad receives the same amount but saves up to $450 in taxes.
But what about car expenses? Most pastors own their own cars and use them for both business and pleasure. Specific cost reimbursement for costs of the pastor’s car used on church business is easy for gasoline, oil, and repairs, but what about replacement (depreciation)? One solution is a specific centsper-mile allowance. If such an allowance is 21 cents or less per mile, nothing is reported on the employee’s tax return. However, 21 cents may not cover the costs of operating that car, and any larger cents-permile allowance is taxable.
Another solution is for the congregation to provide and pay all the expenses of a church-owned or leased automobile. It sometimes can be done without costing the congregation anything more than would be paid for reimbursement.
Miscellaneous provisions
Social security (self-employment tax for clergy) costs continue to rise. Nonordained church employees will pay 7.15 percent of salary for FICA social security taxes in 1987 (7.51 percent in 1988). All employers, including churches that have not received an exemption, will contribute an additional 7.15 percent employer tax in 1987.
Churches, however, cannot pay social security tax on behalf of ordained clergy. Clergy personally pay the self-employment social security tax of 12.3 percent in 1987 (13.02 percent in 1988).
Since clergy pay so much more social security tax than do other employees, and churches contribute nothing for them, it makes sense for congregations to assist in paying this constantly rising tax. A reasonable allowance (fully taxable for the pastor) would be at least 7.15 percent in 1987 (7.51 percent in 1988). That way the congregation pays no more than it would have paid if the pastor were considered an employee.
Retirement planning remains much the same under the new tax law. Although both church pension boards and commercial insurance company annuities provide similar benefits, the church pension board can designate the entire pension as housing allowance, making it potentially excluded from taxes; the insurance company cannot make that designation, in which case annuity income is fully taxable. The new tax law generally limits contributions to a tax-sheltered annuity to $9,500 a year or 20 percent of taxable compensation, whichever is less.
Life insurance premiums paid by the congregation on up to $50,000 coverage for a group term policy are not taxable income for a pastor.
It’s a new ball game in 1987. But with some thought and the willingness to bend a little, churches can help their pastors receive all the benefits to which they’re entitled.-Manfred Holsk, Jr., C.P.A. Church Management, Inc.
Austin, Texas
Copyright © 1987 by the author or Christianity Today/Leadership Journal. Click here for reprint information on Leadership Journal.
