Clergy members carry “dual tax status,” meaning they are considered “self-employed” for Social Security purposes but considered an “employee” for income tax purposes. Because of this dual status, many clergies do not file their taxes correctly and often miss-out on tax benefits.
One example of an unusual tax benefit is the exclusion of a housing allowance or fair value of a parsonage from federal income taxes. This exclusion, combined with dual status, can make matters even more confusing.
Understanding the following top ten mistakes clergy make when filing taxes will help you file correctly in the future:
- Treatment of Ministers as Independent Contractors. Most ministers do not qualify as independent contractors for income tax purposes, though they are considered self-employed for social security tax purposes. A church or other organization generally has sufficient control over the minister to establish an employer-employee relationship. As such, ministers should receive a W2 from their employer, minus a few exceptions. Ministers are exempt from employer withholding of federal income tax and Social Security tax. Instead, ministers should be remitting their tax liability to the government via quarterly estimated tax payments.
- Not Limiting Housing Allowance. Ministers receive a housing allowance benefit that is exempt from federal income taxes, but subject to social security taxes. Housing allowance should be limited to the lesser of a) the fair rental value of the home plus utilities and maintenance, b) actual housing expenses incurred, or c) the amount designated by the employer. Some employers designate a large percentage of compensation as housing allowance to provide the minister with the greatest tax benefit. The amount designated as housing allowance is only one of the limiting factors; actual housing expenses incurred and the fair rental value are two other limitations that must be considered. In 2002, Congress enacted the Clergy Housing Allowance Clarification Act to limit the amount of housing allowance exclusion to the fair rental value of the property of the home, including furnishings and the cost of utilities. This was in response to publicized abuses by high-profile ministers who were deducting mega housing allowances. The limitation of housing allowance to the fair rental value means that a minister will not be able to make a significant house renovation and deduct all of the costs.
- Failure to Report Excess Housing Allowance as Taxable Income. Using a housing allowance is a tax-free benefit. Some clergy assume the entire amount designated as housing allowance is excludable from income, but it’s not. The minister should maintain a record of all housing expenses to substantiate the housing allowance claimed on their return. To the extent that actual housing expenses are less than the amount designated as housing allowance, the minister is required to report the excess housing allowance as taxable income on their return.
- Failure to Apply the “Deason Rule”. Based on the Deason Rule versus Commissioner of Internal Revenue court case from 1964, ministers must allocate a portion of their deductible business expenses to their tax-free housing allowance. Assume that a minster has a total compensation package of $40,000 that includes $30,000 of salary and $10,000 for housing allowance. Assume that the minister has another $10,000 of income from speaking, weddings, funerals, and writing. Total income from being a minister equals $50,000, with $10,000 being exempt from federal income taxes. The minister must limit any business expenses related to the minster activity by 20 percent, $10,000/$50,000. If the minister claimed $2,000 of business expenses, then $400 would be allocated to tax-free income per the Deason Rule and would not be deducted on the return.
- Improperly Taking Office-in-Home Deduction. A home office must be used for the convenience of the employer and the employer has no other fixed location where the minister conducts substantial administrative or management activities. Ministers generally have an office at their place of employment precluding the office-in-home deduction. Secondly, a home office deduction is not allowed if the minister is receiving a tax-exempt housing allowance. To do so would be claiming the same expenses twice which is not allowed.
- Not Treating Social Security Reimbursement Properly. Many employers provide a Social Security offset payment to the minister to reimburse for having to pay the “employer” portion of FICA through their self-employment tax. These reimbursements are fully taxable to the minister and should be included on the W2 as taxable wages.
- Taking Undistributed Expenses Account Payments. If an employer reimburses a minister under an accountable plan for business expenses, auto, travel, meals, supplies, etc., the reimbursement is not taxable and should not be reported as compensation. To qualify as an accountable plan there must be substantiation for the reimbursement documenting the actual expense. If the employer makes periodic payments to the minister without substantiation of the expense or pays out any unused amounts from the expense account at the end of the year, the payments would not meet the requirements of an accountable expense reimbursement plan. Paying out unused money from an expense account automatically makes the expense account a non-accountable plan. This makes all of the expense payments taxable as compensation.
- Failure to Adequately Substantiate Business Expenses. Minister expenses that are not reimbursed through an accountable plan may be deducted on their tax return. The IRS has clear documentation rules requiring substantiation of business expenses. It is a best practice to document the who, what, when, where and why the business expense occurred. A minister should be able to explain the purpose, relationship, cost, time, and place of any expense. It is important for a minister to maintain accounting records and documentation to support the business expenses that they claim.
- Failure to Pay Quarterly Tax Estimates. The US tax system is a pay-as-you-go system, which means that you must pay income tax as you earn or receive your income during the year. Regular employees have their tax liabilities withheld from their paychecks and remitted to the IRS by their employers. Ministers are exempt from this withholding requirement. Instead, ministers generally make quarterly estimated tax payments to the IRS. Failure to have sufficient taxes paid into the IRS could result in underpayment penalties. Taxpayers will avoid the underpayment penalty if they owe less than $1,000, or if they paid at least 90 percent of the current year tax or 100 percent of the prior year tax, whichever is smaller.
Tax compliance for clergy can be challenging. Before you are tripped up by one of these common mistakes, contact PBMares for professional help in navigating these tax requirements.