Tax Planning for Clergy

Accountable plans & housing allowance help keep minister's taxes under control

Scenic photo of Saint Matthew's Church in Kunkletown, PA.
© 2011 Nicholas A. Tonelli / flickr

"What can I deduct?"

That is the number one question that ministers ask about their taxes, says Dr. John Stancil. He's a certified public accountant who specializes in preparing tax returns for clergy and ministers.

"But," Dr. Stancil added, "that's not the right question to ask. It's the way their compensation package is set up at the church. Is it set up to minimize their tax liability?"

John said there's a couple of things going on here.

"Some churches," he said, "utilize simply a travel allowance, say five hundred a month. If the minister does not have to account to the church for that, then that five hundred a month travel allowance is included in the minister's taxable income and we have to deduct the travel expenses as a miscellaneous deduction on Schedule A."

Miscellaneous deductions on Schedule A are limited. And the minister may or may not be able to itemize. And even if expenses are deducted, the deduction is only against the income tax. The minister will still have paid self-employment tax on the reimbursement amount. Add all these reasons up, and ministers aren't getting reimbursed for the full dollar amount of their ministerial expenses.

There's a better way to set things up. "Turn the flat amount into an accountable reimbursement plan," John said.  "And change from travel allowance to professional expense allowance.

Now the minister can spend it on something other than travel." With accountable reimbursement plans, you see, the minister has to give receipts and other documentations to the congregation to account for out-of-pocket expenses. The rule is, basically, if you hand over your receipts and make a proper accounting to the congregation, then the reimbursement is tax free.

It's not added to the minister's wages. It's not subject to income tax or self-employment tax. Those same expenses cannot be deducted on Schedule A. That would be double-dipping. 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 their budget. But the same five hundred dollars 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.

John Stancil was helping a pastor with a tax audit one time. The client didn't have a lot of receipts to back up his deductions. John said the IRS agent and him were going at it "tooth and nail." When the agent left the room for a moment, John looked over at his client cowering in the corner of the room. "Let's just write him a check. I just want this to be over with," the client moaned. "Do you know how much it will cost you to get it over with?," John asked. The client shook his head. "About two thousand dollars."

"That made a believer of him," John said.

"We're looking partly at how the minister is being compensated and how being reimbursed," John went on to say, "Another aspect is the housing allowance, which is subject to the self-employment tax but not the income tax.

We can set it up to 100% of salary." John went on to explain, "If we set the housing allowance too high, then 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 is just housing allowance or salary. There's no tax difference to the church, but there's a tax difference to the client."

John pointed out there are rules and limits for the housing allowance. "The housing allowance is limit is 100% of salary, must be reasonable, cannot be more than amount spent on housing, cannot be more than fair rental market.

Mortgage payments, property tax, insurance, up keep, routine cleaning, 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, although it's still subject to the self-employment tax. "The more they can shift into housing allowance escapes federal and state income tax, but still subject the self-employment tax," he said.

Speaking of the self-employment tax, ministers occupy a rather unique position in the tax code. "If they are ordained, licensed or commissioned, then they are self-employed for Social Security purposes. For income tax purposes they are considered employees." This dual status as partly an employee and partly as self-employed has significant tax consequences. Like employees, ministers get a W-2 to report their earnings. This is reported on line 7 of Form 1040, just like other wages. Any out-of-pocket ministerial expenses they deduct on Schedule A as miscellaneous deductions. But their W-2 income is subject to the self-employment tax. That is, ministers pay both halves of Social Security and Medicare taxes, a combined 15.3% on top of their income tax. Any supplemental income, John noted, goes on Schedule C. This could 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.

Ministers can opt out of the self-employment tax. "They have to opt out by the second year in which they have $400 or more of ministerial earnings," John said. "You don’t have any ministerial earnings until you are ordained, licensed. Only when 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," notes John. Merely not wanting to pay self-employment tax is not a sufficient reason.

Because there's a two-year window for opting out of Social Security and Medicare taxes following ordination, ministers sometimes opt out early in their careers, "and many later regret the decision," John said. When opting out, the ministerial earnings don't count towards future Social Security and Medicare benefits. Ministers may have no or lower retirement or disability benefits from Social Security, and they might not earn enough Social Security credits to even be eligible for these benefits at all. But not all is lost.

"Secular employment earns Social Security credits," John notes. "This is a way to help provide for their retirement." So getting a side job, say teaching at a college or part-time office work, produces wage income that's subject to Social Security and Medicare taxes – even if the minister has opted out of these taxes for his ministerial earnings. This helps the minister accumulate annual Social Security credits towards future retirement and disability benefits. The one thing ministers cannot do? "They cannot opt-in a few years down the road," John said.

Plant Seeds Now for Future Goals

"Particularly if they have opted out of Social Security, putting some money into IRA or retirement plan," is a core financial planning tactic – especially since "most churches underfund [their] retirement plan," John notes. Beside the church's pension or retirement plan, ministers can save money through a tax-deductible Traditional IRA or a not-deductible-but-possibly-tax-free Roth IRA. If they have supplemental income on a 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 plans for when they retire. When they retire, they won't have a home. Make plans for that eventuality," advises John.

Tax Planning Checklist for Clergy

  • Housing allowance needs to be set in advance by the congregation, and the amount "can only be increased prospectively," John says.
  • Negotiate how to allocate any raises between salary and housing allowance.
  • Save receipts and other documentation of out-of-pocket ministry expenses.
  • Set up accountable reimbursement plan if you currently have a non-accountable plan.
  • Within 2 years of being ordained or licensed, decide whether to opt out of Social Security on ministerial earnings.
  • Save for retirement.
  • Buy a house, especially if you live in a parsonage provided by the congregation.
  • Retain, in your permanent records, Form 4361 sent back as approved by the IRS. Make one copy to give to your accountant.

Source:

Dr John Stancil is a certified public accountant in private practice in Lakeland, Florida, and he specializes in preparing tax returns for ministers and clergy. He recently launched ChurchTaxSolutions.com to help churches and non-profit organizations understand their tax responsibilities.

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