Tax Planning and Considerations for Clergy Members
When it comes to taxes, ministers ask the same question that just about everyone else does: "What can I deduct to save some money?" But Dr. John Stancil, a certified public accountant who specializes in preparing tax returns for clergy and ministers, says that's not the right question to ask.
Instead, clergy should question how to achieve their best possible tax situations overall rather than just focus on deductions. There are a few moving, interlocking components when it comes to preparing your taxes when you're in this profession. Is your compensation package set up to minimize your tax liability?
"Some churches simply use a travel allowance, say $500 a month," Stancil told us. "If the minister does not have to account to the church for that money, that $500 allowance is included in the minister's taxable income. We'd have to deduct the travel expenses as a miscellaneous deduction on Schedule A to balance that."
Miscellaneous deductions on Schedule A are limited to the portion that exceeds 2 percent of your adjusted gross income, so it might not be in your best interest to do this. You might be better off overall claiming the standard deduction for your filing status, which ends up being more for many taxpayers.
Furthermore, this itemized deduction can only reduce the amount of your income that's subject to income tax. A minister would still have to pay self-employment tax on the reimbursement amount.
There's a Better Way
"Turn the flat amount into an accountable reimbursement plan," John suggested. "Change it from a travel allowance to a professional expense allowance. Now the minister can spend it on something other than travel."
With an accountable reimbursement plan, the minister would have to give receipts and other documentation to the congregation to account for his out-of-pocket expenses. Basically, if you hand over your receipts and you make a proper accounting to the congregation, the reimbursement becomes tax-free. It's not added to your wages or salary, and it's not subject to either income tax or self-employment tax.
The benefit here is that the minister is reimbursed in full for out-of-pocket expenses. The congregation can still set a limit based on its budget, but the $500 a month will go a lot further if taxes aren't in the way. An accountable plan does something else, too. It forces the minister—and the congregation—to properly account for ministerial expenses with receipts, but those same expenses can't also be deducted on Schedule A if you decide to itemize. That would be double-dipping.
"Another aspect of compensation is the housing allowance, which is subject to the self-employment tax but not the income tax. We can set it up to 100 percent of salary," Stancil explained. "If we set the housing allowance too high, the extra amount is treated as taxable income, but that would have happened anyway. So the goal is to set the housing allowance high and not more than the fair rental value of the parsonage. Setting the housing allowance doesn't affect the church at all—it's just housing allowance or salary.
There's no tax difference to the church, but there's a tax difference to the client."
There are rules and limits for the housing allowance. "It's limit is 100 percent of salary. It must be reasonable, it cannot be more than the amount actually spent on housing, and it cannot be more than fair rental market. Mortgage payments, property tax, insurance, upkeep, routine cleaning, and utilities can all be included in the housing allowance—virtually anything related to the house."
The key benefit of the housing allowance is that it's exempt from federal and state income tax. "The more money a minister can shift into his housing allowance, the more money will escape federal and state income tax, but it's still subject the self-employment tax," Stancil said.
Speaking of the Self-Employment Tax
Ministers occupy a rather unique position in the tax code when it comes to the self-employment tax, which represents Social Security and Medicare taxes. Normally, an employee would pay one half of these taxes and his employer would match that amount. But if a minister is ordained, licensed, or commissioned, he's considered self-employed for purposes of Social Security, even though he's considered an employee for income tax purposes.
This dual status partly as an employee and partly as a self-employed individual has significant tax consequences. Like employees, ministers get a W-2 that reports their earnings. They must report this income on line 7 of Form 1040, just like other wages. Any out-of-pocket ministerial expenses they claim would then be miscellaneous itemized deductions on Schedule A.
But their W-2 income is also subject to the self-employment tax, assuming that the congregation did not contribute or withhold any Social Security or Medicare taxes from those earnings. That is, ministers pay both halves of Social Security and Medicare, a combined 15.3 percent on top of their income tax as of 2018.
Any supplemental income goes on Schedule C, which calculates self-employment income. This might be income from a side ministry such as performing weddings. Supplemental income is also subject to the federal and state income tax and the self-employment tax.
The Opt-Out Option
Ministers can opt out of the self-employment tax, however. "They have to opt out by the second year in which they have $400 or more of ministerial earnings," Stancil told us. "You don’t have any ministerial earnings until you are ordained or licensed. It's when you're ordained or licensed that the two-year window opens."
A word of caution here: Ministers can opt out of Social Security and Medicare because of an objection to receiving public insurance in relation to ministerial earnings. Merely wanting to avoid paying self-employment tax is not sufficient reason.
Ministers sometimes opt out early in their careers because of that two-year window for doing so, and many later regret the decision. Your ministerial earnings won't count toward future Social Security and Medicare benefits if you opt out. Ministers might eventually receive less in the way of retirement or disability benefits from Social Security, and they might not even earn enough Social Security credits over the course of their careers to be eligible for these benefits at all.
Planning for Retirement
But not all is lost. "Secular employment earns Social Security credits," Stancil said. "This is a way to help provide for your retirement." Getting a side job—such as teaching at a college or part-time office work—produces wage income that's subject to Social Security and Medicare taxes even if you've opted out of these taxes for your ministerial earnings. This helps the minister accumulate annual Social Security credits toward future retirement and toward disability benefits.
Putting some money into IRA or retirement plan is a core financial planning tactic, too, particularly for ministers who have opted out of Social Security. Most churches underfund their retirement plans, but ministers can also save retirement dollars through tax-deductible Traditional IRAs or a not-deductible-but-possibly-tax-free Roth IRA. If they have supplemental income on Schedule C, they might be eligible for a SEP-IRA.
Ministers should also think about buying a house as part of their retirement goals. If the minister lives in a parsonage provided by their church, "I encourage them to make some housing plans for when they retire. Otherwise, they won't have a home after that point. Make plans for that eventuality," advised Stancil.
A Tax-Planning Checklist for Clergy
- Your housing allowance should be set in advance by the congregation and the amount can only be increased prospectively.
- Negotiate how to allocate any raises between salary and your housing allowance.
- Save your receipts and other documentation supporting out-of-pocket ministry expenses.
- Set up an accountable reimbursement plan if you currently have a non-accountable plan.
- Decide whether to opt out of Social Security on ministerial earnings within two years of being ordained or licensed.
- Save for retirement.
- Buy a house, especially if you live in a parsonage provided by the congregation.
- Retain a copy of Form 4361 if you opt out of the self-employment tax. You'll want a copy that's been marked as approved by the IRS. Keep it in your permanent records and make one copy to give to your accountant.
Source: Dr John Stancil is a certified public accountant in private practice in Lakeland, Florida. He specializes in preparing tax returns for ministers and clergy.