Recently the Internal Revenue Service issued “audit guidelines” for ministers’ tax returns. Here are attorney and accountant Richard Hammar’s conclusions of the risks and benefits of the new guidelines.
Is a minister an employee or self-employed?
The guidelines inform agents that most ministers are employees for income-tax reporting purposes, and that this is “the first issue that must be determined.” The guidelines do not say that all ministers are employees but “are generally considered employees.” Self-employed status will be the exception, however, and any minister reporting income taxes as self-employed must expect to have his or her status challenged if audited.
Who is a “minister”?
Happily, the guidelines apply a flexible definition of the term “minister.” It is more likely that associate pastors, and clergy employed by seminaries and parachurch ministries, will be considered “ministers” for federal tax purposes. There is less risk of an auditor challenging ministerial status.
What is considered “income”?
The guidelines urge agents to look for several kinds of taxable income that may not have been reported, including:
- “Special gifts.” It is more likely that ministers will be asked if they received gifts during the year (for example, on a birthday, an anniversary, Christmas, or retirement). In most cases such gifts are taxable—especially if funded through offerings collected during church services from donors who receive charitable giving credit for their contributions.
- Business expense reimbursements. Many ministers are reimbursed for business expenses under a “nonaccountable” reimbursement arrangement. For example, your church pays a monthly car allowance to staff members, without requiring substantiation. Or your church reimburses business expenses without requiring receipts for expenses of $75 or more, with the date, place, and business purpose of each expense. Or your church reimburses business expenses once each year, rather than within a “reasonable time” (generally 60 days or less). Or your church provides travel advances and requires no accounting for the use of these funds. First, all such nonaccountable reimbursements must be reported as taxable income to the minister (on a W-2 or 1099). Second, ministers can deduct such expenses only as miscellaneous itemized deductions on Schedule A. (Ministers who cannot use Schedule A lose any deduction for their nonaccountable business expenses, even though they must report all of their church’s reimbursements as taxable income.) If you have a nonaccountable reimbursement arrangement, immediately convert it to an accountable arrangement.
- Amounts paid to cover self-employment tax or income tax. Many churches pay ministers an additional amount to help them meet their self-employment tax obligations. Such “contributions” represent taxable income to the minister and will likely be identified in audits. The same rule applies to any amounts paid to a minister by a church to cover income taxes.
What risks come with housing allowances?
Increased audit risks face ministers as a result of the new guidelines:
- Designations in advance of the year. Unfortunately, the guidelines state the housing allowance “only applies if the employing church designates the amount of the allowance in advance of the tax year.” While this statement is not true, it will make it far more likely that IRS auditors will question ministers’ housing allowances that are not designated prior to the beginning of each new year. It is best to play it safe: Have all housing allowances designated prior to the beginning of the applicable year.
- The “fair rental value” limitation. The guidelines clearly instruct agents that ministers who own their homes can exclude from taxable income “the least of (1) the amount actually used to provide a home, (2) the amount officially designated as a housing allowance, or (3) the fair rental value of the home, including furnishings, utilities, garage, etc.” In other words, ministers cannot simply exclude the housing allowance designated by their church if one of the other limitations applies. Many ministers have ignored the other limitations, and particularly the “fair rental value” limitation. All three limitations will likely now be applied, and a minister’s housing allowance exclusion will be limited to the lowest of the three amounts.
- Housing allowances paid to retired ministers. The guidelines instruct IRS agents to be sure that retired ministers report any housing allowance they receive from a retirement plan as taxable for purposes of the self-employment tax. Most retired ministers do not presently follow this rule, and the guidelines’ position on this point is most unfortunate. On the other hand, the guidelines confirm that retirement plans can designate housing allowances for retired ministers and that such allowances are tax-free for income tax reporting purposes (if legal requirements are met).
What is legitimately a business expense?
Here are increased audit risks to be aware of:
- Salary-reduction arrangements. Does your church reimburse your business expenses by reducing your salary? This is a question auditors will be asking ministers as a result of the guidelines. Such arrangements are not illegal or improper, but since they cannot be accountable, all reimbursements must be reported as taxable income to the minister.
- Business use of a home. The guidelines instruct agents to “question closely” the necessity of a home office. This expense should not be claimed unless there is a reasonable basis for it.
- Personal use of business equipment. Many ministers own computers that they use for both business and personal use. The guidelines make it more likely that ministers will be asked to prove the percentage of time the computer is used for business purposes.
- Contributions to a church or denominational agency. The good news is that the guidelines concede that modest annual renewal fees paid to a denominational agency that are required to maintain a minister’s credentials are deductible. On the other hand, contributions made by ministers to their employing church are not business expenses but must be reported as charitable contributions.
- The “Deason” allocation rule. The guidelines instruct agents to apply the so-called Deason allocation rule. This requires that a minister’s business expense deduction (for income-tax reporting purposes) be reduced by the percentage of total compensation that is tax-exempt as a housing allowance. The good news is that the rule can be avoided completely if a church simply adopts an accountable business expense reimbursement arrangement. Richard R. Hammar is an attorney and certified public accountant, and editor of Church Law & Tax Report.
*************************
Excerpted by permission from Church Law & Tax Report (September/October 1995).
1996 Christianity Today/LEADERSHIP Journal
