 Church & Official Worker Taxes
Topics and Questions
• Employment Status of the Minister and Staff
• The Housing Allowance
• Reporting to Tax Authorities
• IRS Section 501(c)(3) and the C&MA Group
Exemption Letter
• Charitable Donations
• Unrelated Business Income
• Handling Business Expenses
• Income/Compensation
• Political Activity
• State and Local Taxes
»Resources
Current Issues and Alerts
• Housing Allowance Limitation: Warren v. Commissioner of Internal Revenue
• State Unemployment Taxes: Newport Church of the Nazarene v. Hensley
• IRS Publication 78: Where is the C&MA?
Employment Status of the
Minister and Staff
Is the minister an employee or self-employed? Except
in rare circumstances, the minister(s) of a church should be
considered an employee for income tax purposes. The reasons
for this classification are as follows:
- The IRS considers most ministers to be employees
of the church.
- Most ministers are employees under the tests
applied by the courts.
- The risk of an audit is much lower (IRS
focuses on persons for potential audit who receive only one
1099).
- The value of some fringe benefits will be
nontaxable, including 1) expense reimbursements under an
accountable reimbursement plan and 2) medical insurance premiums
paid directly or reimbursed.
- If the IRS reclassifies a minister from
self-employed to employee, additional taxes and penalties
will be assessed against the minister.
It is important to understand that the minister is considered an
employee for income tax purposes but is considered self-employed
for Social Security purposes and therefore must file self-employment
taxes. This is known as the dual tax status of a minister and creates
much confusion for those reporting to the IRS. See
Chapter 6 of the Finance Manual for more information
on the dual tax status of a minister.
Ministers that will, in all likelihood, be treated as self-employed
for ministerial services rendered to the church are itinerant evangelists,
pulpit supply, C&MA
missionaries, and guest speakers.
Are non-ministerial staff considered employees or are they
self-employed? A determination must be made for each person who does
work for or provides services to the church. This determination should be made
based on the same factors applied to ministers. IRS Form SS-8 contains a checklist
of the twenty criteria the IRS applies. The church should review these criteria
for each individual working for the church if there is any doubt as to their
classification. Many times the classification is easy to determine, but in a
few cases it is a little more difficult, such as a part-time custodian or nursery
worker. For more information on this issue see Chapter
7 of the Finance Manual.
There are some significant differences in reporting taxes to the IRS for the
minister versus the non-ministerial staff. The section on Reporting to Tax Authorities
will attempt to address these differences.
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The Housing Allowance
What is a housing allowance? A housing allowance is a
federal tax exclusion from reportable gross income for income tax purposes. A
housing allowance is an exclusion from ministerial compensation only and never
from secular earnings. The term “housing allowance” is used at times
for the three forms of housing exclusions.
- Parsonage. A house provided by the church. The annual rental value
of the house is not taxable for income tax purposes but must be included
as income for self-employment taxes.
- Parsonage Allowance. When a parsonage is provided
by the church, the church can still designate a portion of the minister’s salary as
parsonage allowance, which is excluded from reportable gross income for income
tax purposes but not from the self-employment tax calculation. This portion
of the minister’s salary can be used for housing related expenses not
paid by the church.
- Housing Allowance. This is the portion of the minister’s
salary that is designated for housing expenses when the minister owns or
rents a house. This amount is excluded from reportable gross income for
income tax purposes but not for self-employment tax purposes.
The term “housing allowance” will be used throughout the remainder
of this section for that portion of the minister’s salary designated
as either a parsonage allowance or a housing allowance, unless noted otherwise.
Who qualifies for a housing allowance? To qualify for a housing allowance,
a person must be a “minister” for federal tax purposes based on
the following factors:
- Must be ordained, commissioned, or licensed.
- Administers the sacraments.
- Conducts religious worship.
- Has management responsibility in a local church or religious denomination.
- Is considered a religious leader by the church or denomination.
The IRS and the courts generally require the first factor, but the remaining
four need not all be present for the person to be considered a minister for
tax purposes.
When and how is a housing allowance determined and designated? A housing
allowance must be determined in advance of the housing expenses being incurred.
A housing allowance can never be retroactive. Therefore, the governance authority
of the church should designate a housing allowance prior to the beginning of
the coming tax year (e.g., December meeting) or at the beginning of employment.
To avoid the unintended failure to designate an allowance for the next tax
year, the governance authority should pass a continuing resolution to be included
in the written minutes that designates the amount of the housing allowance.
A housing allowance can be amended during the year but only on a prospective
basis.
The amount of the housing allowance should be based on a reasonable estimate
of housing expenses expected to be incurred by the minister for the covered
period. It would be wise to include an additional amount in the housing allowance
for any unexpected expenses since the minister will declare any excess housing
allowance as other income but cannot exclude more than the officially designated
housing allowance.
How much of the minister’s compensation is excludable as housing
allowance? The minister can exclude the lesser of the following three
amounts:
- The amount actually spent on housing expenses for the year.
- The church designated housing allowance.
- The fair rental value of a furnished house including utilities.*
*This applies to ministers who are purchasing a house and not to those renting
or in a parsonage.
What kind of housing expenses are excludable? The following kinds of
expenses should be considered when calculating the housing exclusion:
- Down payment on a house (remember the fair rental value limitation).
- Mortgage (including principal and interest) or rental payments.
- Real estate taxes.
- Property insurance (real estate and personal).
- Utilities (e.g., electricity, gas, water, sewage, trash pickup, local telephone
access charges).
- Furnishings and appliances (purchase and repair).
- Remodeling and physical repairs.
- Yard maintenance and improvements.
- General maintenance items (e.g., exterminations, light bulbs, cleaners).
What can be done to assist a minister who lives in a parsonage but someday
may need to buy a house? The church should consider providing the minister
with an equity allowance. An equity allowance is designed to partially compensate
the minister for the missed opportunity of building equity in a house. The
equity allowance is additional compensation, but placing this compensation
in a tax-deferred retirement vehicle can reduce the tax impact and help ensure
that funds are available at retirement.
How is the housing allowance reported on the W-2? Since the housing
allowance is excluded from the minister’s compensation for income tax
purposes, Box 1 of the W-2 includes the reportable gross income of the minister
after reduction for the housing allowance. It is recommended that the housing
allowance be placed in Box 14 for informational purposes. If the actual housing
expenses are less than the official housing allowance, the minister must report
any excess housing allowance as taxable income.
Where can I find more information on the housing allowance? A number
of resources are listed on the Resources Web page to assist you in finding
more detailed information. One of those resources is the Finance Manual
for Alliance Church Treasurers (FinanceManual). The
housing allowance is discussed in Chapter 6 (found in the Fiance Manual for Church Treasurers).
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Reporting to Tax Authorities
When and how does the church report to the IRS? Since the church
is exempt from paying income taxes on its revenues (except in rare occasions),
the main reporting requirement for the church is related to payroll taxes.
These reporting requirements are mainly for the IRS and Social Security
Administration. There also may be state reporting requirements. The normal
federal payroll reporting requirements for churches are as follows:
- Obtain an employer identification number
(EIN).
- Determine the employment status of each
minister and non-ministerial staff.
- Obtain each person's Social Security number
or EIN.
- Obtain a W-4 from each non-ministerial employee
and from any minister who volunteers to submit to the withholding
of income taxes.
- Based on their salaries and other income,
determine how much income tax to withhold from their paycheck
(Circular E provides tables and instructions).
- For non-ministerial employees, determine
the amount of FICA taxes to withhold.*
- Withheld income taxes and FICA, along with
the employer's match for FICA, are sent to the taxing authority
quarterly using IRS Form 941 or to a local bank more frequently
using IRS Form 8109 if the remittance is greater than $2,500
in any given month.
- File Form 941 with the IRS quarterly to
report the wages that were paid and the taxes withheld.
- Annually, you must issue W-2's to each employee
and file copies of all W-2's with:
• Social Security Administration
using Transmittal Form W-3.
• State and local tax authorities (if required).
- Annually, you must issue 1099s to any non-employees
for services provided if your total payment to them was $600
or more for the year and file copies of all 1099s with:
• IRS using Transmittal
Form 1096.
• State and local tax authorities (if required).
* This assumes the church did not exempt itself
from the employer's share of Social Security taxes in 1984.
The above topic is discussed in detail in Chapter 7 of the Finance
Manual.
If the church's only employee is a minister reporting may be minimal depending
on factors related to the dual tax status of the minister. Even though the minister
is considered a church employee for income tax purposes, the minister's compensation
is specifically exempted from mandatory income tax withholding. This does not
mean the minister is exempted from paying income taxes but only from mandatory
withholding. The minister is required to file and pay a quarterly estimate using
Form 1040 ES. The minister may voluntarily agree to be subject to the withholding
of income taxes by completing Form W-4. This is helpful to the minister if cash
flow is an issue when filing the quarterly estimate.
Since the minister is always considered self-employed for Social Security purposes,
the minister must pay self-employment taxes (SECA). The minister is never subjected
to FICA taxes. The minister is required to file and pay a quarterly estimate
of SECA taxes using Form 1040 ES.
Therefore, if the only employee is the minister and the minister is filing quarterly
estimates, then there is no effective purpose in filing a quarterly Form 941
since its purpose is to report and pay both income taxes withheld and FICA payments.
The IRS agrees with this position, but this position may also create an apparent
discrepancy at the end of the year. The discrepancy will be created because the
church is still required to file a W-2 for the minister even though it did not
report the minister's wages on Form 941. If the church gets an inquiry from the
IRS because of this apparent discrepancy, simply inform the agent that the W-2
was for a minister who filed his own quarterly estimates.
Does the church have to file an IRS Form 990 like other nonprofits? The
short answer to this question is no. Form 990 is the Return of Organization Exempt
From Income Tax and churches are specifically excluded in the IRS code from filing
this form. It is possible that a church could be required to file Form 990T.
This form is entitled Exempt Organization Business Income Tax Return. The 990T
is used to report and pay income taxes on unrelated business income (UBI). We
will discuss UBI in another section due to its complicated nature.
Does the church have to file IRS Form 940? Form
940 is the Employer's Annual Federal Unemployment (FUTA) Tax Return. The church
is not subject FUTA taxes and no form needs to be filed.
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IRS Section 501(c)(3) and the C&MA Group Exemption
Letter
What does it mean to be a tax-exempt organization? A
tax-exempt organization is one that is exempt from paying federal income taxes
on its revenues, including contributions, interest, or investment income. Depending
on the state the church is located in, the organization also may be exempt from
any state income taxes. It does not mean the church is automatically
exempt from all types of federal taxes, nor does it mean that the church is automatically
exempt from various state imposed taxes like sales and property taxes.
What is a 501(c)(3)? This refers to Section 501(c)(3) of the
Internal Revenue Code wherein the criteria are established for an organization
to be considered exempt from federal income taxes. There are six requirements
in Section 501(c)(3) that must be met by the church in order to be considered
exempt. The church:
- Must be incorporated or properly organized under a constitution and/or
bylaws.
- Must be organized exclusively for exempt purposes.
- Must be operated exclusively for exempt purposes.
- Must not allow any of its net earnings to inure to the benefit of any private
individuals.
- Must not engage in any substantial efforts to influence legislation.
- Must not intervene nor participate in political campaigns.
What does a church have to do to be a 501(c)(3) tax-exempt organization? The
short answer is nothing, but this is not an adequate answer. Under IRS regulations,
churches are not required to file anything with the IRS to be tax-exempt under
Section 501(c)(3), but they still must meet all of the requirements mentioned
above.
Why then should a church ever file with the IRS or join the C&MA Group
Exemption to be officially recognized as a 501(c)(3) organization? There
are a number of good reasons for having official documents showing that the IRS
recognizes the church as a tax-exempt organization. One of the main reasons is
to be able to assure the church’s members/donors that their donations will
be deductible if they itemize. Otherwise, should they be audited, they would
be required to prove that the donations were given to a tax-exempt organization.
Another good reason we have seen is in the matter of grants from other organizations.
Almost every time an organization considers a church for a grant it will request
documentation showing the church is a tax-exempt organization. It also may simplify
the process of seeking other federal and state exemptions by being able to show
the federal recognition of the church’s tax-exempt status.
How do we go about getting the church officially recognized as tax-exempt if
we decide it is worthwhile? There are basically two ways to obtain recognition
from the IRS.
- The first way is to file Form 1023 with the IRS and pay a $500 filing fee.
Form 1023 is a very lengthy form and may require the assistance of a certified
public accountant or an attorney.
- The second way is to be included under the
C&MA Group Exemption letter.
This is done by obtaining an employer identification number (EIN) if the
church hasn’t done so already and by completing a one-page application,
which is reviewed by the Office of the Corporate Secretary for completeness
and certain requirements by the IRS. Once this review is completed, a letter,
which documents the church’s inclusion in the Group Exemption, is sent
to the church for its permanent records. The IRS is notified annually of
all additions, deletions, and changes in the members of the Group Exemption.
It is important to keep the Office of the Corporate Secretary informed of
any changes to the church’s purpose, name, or location as we are
required to report these to the IRS annually.
How does a church obtain an EIN? This is accomplished by filing
Form SS-4 with the IRS. It my understanding that if you are in a hurry, you can
obtain one over the phone. Important note: Your church should never have
an occasion to use The Christian and Missionary Alliance’s EIN. In the
past this has led to significant confusion with the IRS. A church plant may have
need to use the district’s EIN but please seek the district’s permission
first.
Can a church add a separately incorporated school or day care to the
C&MA Group Exemption? Because of the nature of the Group Exemption,
separately incorporated subsidiaries of a church generally are not includable
under the Group Exemption letter. This is also true for affiliated churches since
certain IRS requirements for inclusion are not met.
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Charitable Donations
How do I determine if money given to the church is a charitable contribution
and thus tax deductible? This very important question generally can be answered
by determining if the gift meets the following six conditions:
- It is in the form of cash or tangible property.
- It is made before the end of the year in which it is claimed.
- It is made without conditions and does not impart a personal
benefit to the donor.
- It is made "to or for the use of" a qualified
entity.
- Its amount does not exceed legal limits.
- It is properly substantiated.
What if someone like a lawyer or an accountant donates his
or her services? The donation of services or time (volunteer) cannot
be considered a charitable contribution. Actual unreimbursed expenditures that
are a part of the services or time rendered, such as travel costs or mileage,
can be deductible as a donation if properly substantiated. Similarly, forgone
income, such as free rent for an apartment or a piece of equipment, is also not
a charitable donation.
Can the treasurer issue a tax-deductible receipt to
someone who conditions his/her donation by designating a program/project or an
individual? This is one of the most difficult questions a church
treasurer can face because the answer is so fact based, particularly for designations
to individuals. One of the key elements in determining the tax deductibility
of a donation is that it is to be made "to or for the use of" the church. The
IRS understands this to mean that a donation to the church must be for its purposes
and uses as established by the church's governance authority, not by the donor.
- Programs/Projects. The church's governance
authority should establish the program/project prior to any donation being
made and assure that it meets the purposes and uses of the church. When
this is done, a subsequent donation designating the approved program/project
may be treated as a valid charitable donation. A donation that is made
to a nonexisting program/project, with the designation that it be established,
should not be accepted until the governance authority has had the opportunity
to determine its viability and to assure that the program/project is consistent
with the purposes and uses of the church.
- Individuals. The designation
of a donation to an individual generally disallows the deductibility of
the gift. As noted above, a donation designated for an individual would
not be "to" the
tax-exempt entity (i.e., church), but on occasions such a designation could
be "for the use of" the church. The best example of a "for the use of" designation
that is often considered deductible is for a missionary who is under the
control of the church or an exempt organization. Unless designated for
a specific charitable purpose, like the "work of," support designations,
while often deductible, also will be considered compensation to the missionary.
What about other designations for things like benevolent funds, scholarship programs,
or short-term mission trips? Generally, if the designation is for the charitable
purpose itself, the gift will be deductible. Problems arise at times when the
gift is designated for an individual as discussed below:
- Benevolent Funds. The IRS accepts the
use of tax-exempt dollars for the benefit of particular individuals when
such use is in the area of basic needs, like food, clothing, and shelter
and meets the purposes and uses of the church. Any decision related to
the use of tax-exempt funds for benevolent purposes should be made by the
governance authority or its delegated committee, such as the deacons. A
policy should be in place that clearly defines the class of individuals
who may be provided with such assistance and should be broad enough to
encompass a large population of potential beneficiaries. Designated donations
given to the general fund or benevolent fund for the benefit of a specific
individual are not tax deductible. Donations should not be solicited for
particular individuals but may be solicited for replenishing the benevolent
fund. Members may suggest to the governance authority certain individuals
or families that are in need, but the final decision as to recipients and
amounts is the decision of the governance authority.
- Scholarship Funds. Donations to scholarship funds
created by a church can be tax deductible if the fund is properly established,
clearly related to the purposes and uses of the church, and controlled
by the church through its governance authority. All of the issues discussed
above for benevolent funds also apply to scholarship funds. The universe
of potential recipients must be large enough so that the scholarship award
has little or no opportunity to personally benefit a particular donor.
This is extremely difficult when one of the donors to the fund is a parent
or relative of the recipient.
- Richard Hammar, in his Church and Clergy Tax Guide
2003 Edition, suggests a test the church can use in evaluating the
probability that a contribution is deductible by the parents of a potential
recipient would be equal to the total number of potential recipients.
For example, for 2 potential recipients there would be a 2 percent chance
that the parent's donation would be deductible but 40 potential recipients
would mean that there was a 40 percent chance that a donation would be
deductible. Remember, this is only a rule of thumb and not a
hard-and-fast rule. An IRS decision will be based on all of the facts
and circumstances. It is important to realize that contributions to a
scholarship fund by a parent should not be treated as tax deductible
unless there are a significant number of potential recipients.
- Short-Term Mission Trips. First, the governance
authority must approve the short-term mission trip so that it meets the
purposes and uses of the church. The church then determines if it will
fund the costs of the trip from the general fund with no direct contributions
from the participants; through the general fund or a special trip fund
with contributions from either or both the participants and non-participants;
or by participants paying all of their own costs. There also could be a
combination of these three options. Travel expenses that are considered
deductible as charitable donations are transportation costs, including
transportation between the airport/station and the hotel; lodging costs;
and the costs of meals. Also, there is some distinction between contributions
for adults and for minors.
If the church pays all travel expenses with no contributions from the participants,
except for their normal giving to the general fund, then there are no tax consequences,
whether the participant is an adult or a minor, since the governance authority
has determined the purpose of the trip as furthering the church's exempt purpose.
What is unrelated business income and why is it important to my church? Unrelated
business income is income from a trade or business that is regularly carried
on and not substantially related to the performance by the organization of its
exempt purpose or function, except that the organization needs the profits derived
from this activity. An example of this might be the establishment of a T-shirt
shop by the church in order to raise additional money for the ministry. Unless
each T-shirt carries a message specifically related to the church’s exempt
purpose, any income generated from the sale of the T-shirts would be unrelated
business income and subject to the payment of unrelated business income taxes
(UBIT). Furthermore, if the income from the sale of the T-shirts was so significant
that it became the substantial source of income for the church over its normal
donations, the IRS could determine that the church was no longer a tax-exempt
entity but had become a T-shirt business. This would result in the revocation
of the church’s tax-exempt status. It is critical that the church understands
that the use of the income for ministry is unimportant to the IRS in the analysis
of what is unrelated business income.
Within this initial definition, there are three requirements that must be met
for this income to be classified as unrelated business income. An activity will
be considered an unrelated business (and potentially subject to UBIT) if it meets
the following three requirements: (1) it is a trade or business, (2) it is regularly
carried on, and (3) it is not substantially related to the furtherance of the
exempt purpose of the organization. However, there are a number of exclusions
and modifications to this general rule.
The IRS Code contains a number of modifications, exclusions, and exceptions to
unrelated business income. For example, dividends, interest, certain other investment
income, royalties, certain rental income, certain income from research activities,
and gains or losses from the disposition of property are excluded when computing
unrelated business income. In addition, the following activities are specifically
excluded from the definition of unrelated trade or business:
- Volunteer Labor. Any trade or business
is excluded in which substantially all of the work is performed for the
organization without compensation. Some fund-raising activities, such as
volunteer-operated bake sales, may meet this exception.
- Convenience of Members. Any trade or
business is excluded that is carried on by an organization described in
501(c)(3) or by a governmental college or university, primarily for the
convenience of its members, students, patients, officers, or employees.
A typical example of this would be a school cafeteria.
- Selling Donated Merchandise. Any trade
or business is excluded that consists of selling merchandise, substantially
all of which the organization received as gifts or contributions. Many
thrift shop operations run by exempt organizations would meet this exception.
Much of the above comes directly from the IRS web site. To read more, visit the
following site: www.irs.gov/charities
If we determine that the church has generated
some unrelated business income, when and how do we go about reporting
it? An exempt organization that has $1,000 or more
gross income from an unrelated business must file Form 990-T, Exempt
Organization Business Income Tax Return.
We rent our facility to others. Is this
income considered unrelated business income? This
is a tough question to answer in a few words. The simplified answer,
which follows, comes from the IRS Tax Guide for Churches and Religious
Organizations.
Rental income. Generally,
income derived from the rental of real property and incidental
personal property is excluded from unrelated business income. However,
there are certain situations in which rental income may be unrelated
business taxable income.
- If a church rents out property on which
there is debt outstanding (for example, a mortgage note),
the rental income may constitute unrelated debt-financed
income subject to UBIT. (However, if a church or convention
or association of churches acquires debt-financed land for
use in its exempt purposes within 15 years of the time of
acquisition, then income from the rental of the land may
not constitute unrelated business income.) Note: The parenthetical
is called the neighborhood land rule.
- If personal services are rendered in connection
with the rental then the income may be unrelated business
taxable income.
- If a church charges for the use of the parking
lot, the income may be unrelated business taxable income.
Parking lots. If
a church owns a parking lot that is used by church
members and visitors while attending church services,
any parking fee paid to the church would not be subject
to UBIT. However, if a church operates a parking
lot that is used by members of the general public,
parking fees would be taxable, as this activity would
not be substantially related to the church’s exempt purpose, and parking fees are not
treated as rent from real property. If the church enters into a
lease with a third party who operates the church’s parking
lot and pays rent to the church, such payments would not be subject
to tax, as they would constitute rent from real property. Another
couple of exceptions for debt-financed property:
- Property related to exempt purposes. If
substantially all (85 percent or more) of the use of any
property is substantially related to an organization's exempt
purposes, the property is not treated as debt-financed property. “Related
use” does not include a use related solely to the organization's
need for income, or its use of the profits. The extent to
which property is used for a particular purpose is determined
on the basis of all the facts and may include:
• A comparison of the
time the property is used for exempt purposes with the
total time the property is used.
• A comparison of the part of the property that is used for exempt purposes
with the part used for all purposes.
• Both of these comparisons.
If less than 85 percent of the use of any property is devoted to
an organization's exempt purposes, only that part of the property
that is used to further the organization's exempt purposes is not
treated as debt-financed property.
- Related exempt uses. Property
owned by an exempt organization and used by a related exempt
organization, or by an exempt organization related to that
related exempt organization, is not treated as debt-financed
property when the property is used by either organization
to further its exempt purpose.
- Related organizations. An
exempt organization is related to another exempt organization
only if:
• One organization is
an exempt holding company and the other receives profits
derived by the exempt holding company,
• One organization controls the other as discussed under Income From Controlled
Organizations earlier in this section,
• More than 50 percent of the members of one organization are members of
the other, or
• Each organization is a local organization directly affiliated with a
common state, national, or international organization that also is exempt.
Note: The bigger issue
in receiving rental income relates to its impact on any state property
tax exemption.
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Handling Business Expenses
Our church provides the pastor with an allowance
that he can spend on business-related expenditures. Is this the
best way to handle these expenditures? This is certainly one
legitimate way of handling business-related expenditures. The IRS
calls this a "nonaccountable reimbursement plan" for reimbursements
since the pastor and other church employees are not required to
substantiate their expenditures to the church. The total amount
of the allowance is included as compensation when reporting to
the IRS. Since most pastors are employees of the church, this reporting
is done on the W-2.
This also has a significant impact on the pastor when reporting
and paying income taxes. Unlike a self-employed evangelist or an
itinerant pastor who can use Schedule C to report the actual business-related
expenditures, a pastor who is an employee must use Schedule A and
report the expenditures as miscellaneous expenses. These expenditures
are subject to the 2% of adjusted gross income (AGI) limitation
and may not be deductible at all if the itemized deductions on Schedule A are
insufficient.
Because of these detrimental rules, it is more appropriate for the church to
establish an "accountable reimbursement plan". An accountable reimbursement plan
places some additional paperwork on the church that currently rests on the pastor,
but significantly assists the pastor in reducing the reportable compensation
and potential income tax effect. With an accountable reimbursement plan, the
church should not include any reimbursement in the pastor's income in Box 1 of
Form W-2.
To be an accountable plan, the church's reimbursement arrangement must require
the pastor and other employees to meet all three of the following rules:
- Reimbursed expenses must have a business connection, that is, the expenses
must be have been paid or been deductible while performing services for the
church.
- The employee must adequately account for his/her expenses to the church
within a reasonable period of time.
- The employee must return any reimbursement or allowance in excess of the
expenses accounted for within a reasonable period of time.
Any part of the reimbursement that does not meet all three rules is considered
paid under a nonaccountable reimbursement plan. Simply put, the church must require
receipts or other forms of valid evidence for the expenditures that substantiate
the business-related purpose of the expenditure, including amount, date, place
or description, and purpose and/or participants.
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Income/Compensation
What should the church include as income on a pastor's W-2? The
first thing to understand is that the income tax code takes the position that
any money paid to or for an employee is income unless specifically excluded by
the tax code. In addition to the pastor's base salary, there are some items a
church may provide as fringe benefits to the pastor or other employees that the
IRS may include as income. These may include but are not limited to the following:
- Bonuses
- Honoraria, special occasion, and love offerings
- Retirement gifts
- Forgiveness of debt
- Below-market interest loans
- Social Security grant
- Provided auto for personal use
- Provided cell phone for personal use
- Nonaccountable expense reimbursements
- Severance pay
- Spousal travel
- Sick pay
- Moving expenses
- In-kind transfers of property
There are other kinds of income that would generally be considered as income,
except for the fact that they have been excluded within the income tax code or
regulations. Some examples of these are:
Employer Provided
- Housing allowance, excludable for income tax purposes only (previously
discussed).
- Health insurance premiums paid by the employer directly or reimbursed under
an accountable reimbursement plan.
- Medical care reimbursements under an employer sponsored plan.
- Deferred compensation such as a 403(b) plan.
- Employer paid life insurance premiums for coverage up to $50,000 (excess
coverage makes a portion of premium taxable income).
- Educational assistance up to $5,250 per year.
- Free child care if properly established.
- Employer provided housing and meals for employer's convenience, excludable
for income tax purposes only.
Non-Employer Provided
- Gifts from individuals.
- Life insurance proceeds.
- Qualified scholarship money.
How does the church determine the right amount of compensation for the pastor? Besides
the fact that the church should properly compensate its pastor, this is an important
question for two other reasons, both related to making sure the church is paying
its pastor a reasonable compensation. The first reason is that the payment of
unreasonably high compensation can result in intermediate sanctions being applied
by the IRS. The second reason is even harsher since a church could lose its tax-exempt
status if it was determined that compensation being paid to the pastor is unreasonable.
- Intermediate Sanctions. An excise tax that is assessed to the disqualified
person or organization manager. Intermediate sanctions are threefold. The
first sanction is a 25 percent tax on the actual amount of the excess compensation
received by the disqualified person. The second sanction is a 200 percent
tax on the excess compensation if the disqualified person fails to return
the excess compensation within the taxable period. The third possible sanction
is a 10 percent tax, up to $10,000 assessed against the organizational manager,
if he participated in approving the excess compensation.
- Disqualified Person. Any person who was in a position to exercise
substantial influence over the affairs of the tax-exempt organization or
any family member of such a person. The IRS regulations specifically state
that the board members (directors), president and treasurer are presumed
to exercise the necessary level of influence to be deemed disqualified.
- Organizational Manager. Any officer, director (member of the governance
authority), or trustee.
- Excess Compensation. Compensation above the amount that is determined
as reasonable. Compensation for the performance of services is reasonable
if it is only such amount as would ordinarily be paid for like services by
like enterprises under like circumstances.
The IRS regulations establish a safe harbor for boards called the presumption
of reasonableness. It is based on an approval by the board or a committee of
the board that:
- Was composed entirely of individuals unrelated to and not subject to the
control of the disqualified person involved.
- Obtained and relied upon objective comparability information.
- Adequately documented the basis for its decision.
These kind of excess benefit transactions
also include: "any transaction in which
an economic benefit is provided by an applicable tax-exempt organization directly
or indirectly, to or for the use of, any disqualified person, and the value of
the economic benefit provided exceeds the value of the consideration (including
services) received by the organization for providing such benefit."
The intermediate sanction rules clearly cast a shadow over the free-will offering
method that some churches in the United States use in compensating their ministers.
The impact on this method of compensation may be addressed after further research
occurs.
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Political Activity
What kind of political activities are prohibited for churches? As
a condition of their tax-exempt status, churches are prohibited by federal law
from participating or intervening, directly or indirectly, in any political campaign
on behalf of, or in opposition to, any candidate for public office. This prohibition
applies equally to national, state, and local elections. The IRS has issued guidelines
outlining prohibitions of involvement in political campaigns for churches and
other tax-exempt organizations. They state that a church cannot endorse candidates,
make donations to campaigns, engage in fundraising, distribute statements, or
become involved in any other activities that may be beneficial or detrimental
to a candidate. Churches may sponsor debates or forums to educate voters; but
if the forum or debate shows a preference for or against a certain candidate,
it becomes a prohibited activity.
A church can have political candidates address the congregation as long as overt
campaign activities are avoided, the same opportunity is afforded to all other
qualified candidates for the same office, and the congregation is informed before
and after the speech that the church does not endorse any candidate for public
office. Other activities, such as voter education, are permitted as long as they
are neutral in content and format. Rating candidates or even organizing forums
where members of the public rate political candidates can be a problem since
it may encourage people to vote for or against a candidate. The church may publicize
its position on moral and social issues but must not link that position to specific
candidates.
A church should be careful to walk the line between addressing an issue and endorsing
or criticizing a particular candidate and his position on an issue. Pastors need
to be particularly careful in making statements of this type since they may be
viewed as agents of the church. If a pastor wishes to individually make a political
endorsement, he must qualify his remarks by stating explicitly that they are
being made in a private capacity and not as an agent of the church and that the
church has not taken any action to endorse or express its opposition to any candidate.
The time spent by the pastor on political activities must be his personal time
and not compensated by the church.
If the IRS finds that a church is engaged in a prohibited political campaigning
activity, the church could lose its exempt status and also could be subject to
an excise tax on the amount of money spent on that activity. Contributions to
a church that loses its tax-exempt status because of political activities are
not deductible by the donors for federal income tax purposes.
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State and Local Taxes
Does my church’s status as a 501(c)(3) tax-exempt
organization also automatically exempt it from other taxes like property or sales? The
quick answer no. Each state has its own laws related to its income taxes (if
any), property taxes, sales taxes, and other taxes it may implement. The church’s
status as a 501(c)(3) may exempt it from paying these taxes, but each tax must
be investigated to determine its applicability. Your district office may be a
good resource for such information. Generally, churches are exempt from state
income taxes and are able to obtain a property tax exemption in most states,
but the sales tax exemption for either buying or selling is wide open, with each
state having its own rules.
While generally available, property tax exemptions can be very different between
states, particularly when it comes to using the property for nonexempt purposes.
Some states will take away the entire exemption if any part of the property is
used for nonexempt purposes, while other states will prorate between the exempt
and nonexempt use. Some states will even allow minimal nonexempt use without
jeopardizing the property exemption.
Are churches subject to unemployment taxes? On a federal basis,
churches are clearly exempt from the Federal Unemployment Tax Act (FUTA), but
on the state level there is some confusion. Overwhelmingly, churches have been
exempted from state unemployment tax laws, and pastors have not had access to
the various state unemployment systems. A current legal battle in Oregon is addressing
this issue related to a pastor’s right to access the Oregon unemployment
system. See Current Issues and Alerts for more information.
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Housing Allowance Limitation: Warren v. Commissioner of
Internal Revenue
In 2000, the U.S. Tax Court handed down a decision in the Warren v. Commissioner
of Internal Revenue case that determined the exemption for housing allowance
could not be limited to the fair rental value of a pastor's house. This limitation
had been implemented by the IRS in its regulations, but the court found it was
not supported by the language in the law. As a result, the IRS appealed to the
9th Circuit Federal Court of Appeals. Unexpectedly, one of the justices on this
court decided that the constitutionality of the entire exemption should be questioned
and ultimately determined.
As a result, Congress made a preemptive strike against the federal appeals court
regarding the possible revocation of the housing allowance. On May 2 the Senate
passed a bill designed to protect a long-standing tax break for clergy. The House
passed the bill 408-0 and the Senate followed suit, passing it by unanimous consent.
The measure was subsequently signed by the President. Generally, the new legislation
is effective for the 2002 tax year and beyond. It also may be effective for prior
tax years depending on how your pastor(s) filed his tax return.
The legislation instituted a limitation in the excludable amount of housing allowance
for clergy who own their own house, "not to exceed the fair rental value of the
house, including furnishings and appurtenances such as a garage, plus the cost
of utilities."
The question has been asked as to how the fair rental value is determined. The
IRS has not provided any guidance in computing the fair rental value, but it
is likely that any extraordinary expenses (such as a large down payment or major
remodeling) would not be excludable in any one particular year. To avoid this,
it may be necessary to obtain a mortgage or house-improvement loan that could
spread payments over time. One suggestion: To obtain a reasonable estimate of
the fair rental value of his house, a pastor may want to seek professional real
estate assistance to determine the rental values in his neighborhood for a furnished
house, including a garage or shed.
As a result of the legislation, the IRS requested that the case be dismissed
and the federal appeals court did just that, preserving for now the housing allowance
exemption that has been in place since 1921.
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State Unemployment Taxes: Newport Church of the Nazarene
v. Hensle
Several years ago, a former pastor of a Nazarene church filed
for unemployment insurance benefits in Oregon. The church
challenged the award of benefits on several grounds, including
the assertion that including ministers in the unemployment
insurance program violates the Religion Clause of the First
Amendment to the U.S. Constitution. This challenge has been
winding through the court system for several years, with
the church losing each major decision, most recently before
the Oregon Court of Appeals. The Oregon Supreme Court recently
upheld the ruling of the Oregon Court of Appeals, and thus
ruled against the church and in favor of the Oregon Employment
Department. There is currently no word on whether the church
will appeal to the U. S. Supreme Court.
This decision means that, at this time, churches and pastors
are not exempted from the Oregon unemployment laws.
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IRS Publication 78: Where is
the C&MA?
On occasion we receive notification that The Christian and
Missionary Alliance cannot be found in IRS Publication 78,
which is the listing of tax-exempt entities approved by the
IRS. This has come up as a part of a donor’s tax preparation
when the CPA or tax preparer tries to verify the C&MA’s tax-exempt
status. Please be assured that The Christian and Missionary Alliance is tax-exempt
and continues to maintain that exemption. The problem appears to be the way the
C&MA is listed on the IRS web site and in Publication 78. It appears that
the IRS has abbreviated certain items due to space constraints even though it
is not the correct way to display our name or city. For further reference, we
have included the listing as it appears in both locations:
Christian & Missionary
Alliance
Colorado Spgs CO
1
The “1” at the end indicates that the C&MA
has a group exemption letter in place.
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