Tax planning rules for ministers.
For many ministerial tax issues, neither the IRS nor Congress provides detailed guidance, and the courts have issued surprising rulings. As a result, much in the area of taxation of ministers remains a question of professional judgment. The following defines the term "minister" for federal tax purposes, discusses in detail those tax aspects specific to ministers, notes several tax snares that ministers should avoid, and details many opportunities for maximizing the tax benefits associated with being a minister.
Definition of a Minister
The five-factor test. According to the IRS, a minister is someone who is "duly ordained, commissioned, or licensed by a religious body constituting a church or church denomination" (Publication 517: Social Security and Other Information for Members of the Clergy and Religious Workers). In 1987, the Tax Court ruled that in order to be classified as a minister, one must perform the duties and functions of a minister within the three types of services described in the Treasury Regulations (Wingo v. Comm'r, 89 TC 922, 1987). These "services performed in the exercise of ministry" include the ministration of sacerdotal functions; the conduct of religious worship; and the control, conduct, and maintenance of religious organizations (including religious boards and societies) under the authority of a religious body constituting a church or denomination [Treasury Regulations section 1.1402(c)-5(b)(2)].
The Tax Court noted that an individual must perform all three services outlined in the regulations, and the individual must also be ordained, commissioned, or licensed, and considered to be a religious leader by his church or denomination to qualify as a minister. This ruling led to the development of the Tax Court's five-factor test for determining ministerial status, shown in Exhibit 1. The court's decision was in conflict with the specific language of the regulations because it required all five conditions to be met. In 1989, the court refined its position (Knight v. Comm'r, 92 TC 199, 1989). The fourth factor (ordained, commissioned, licensed) is a requirement in all cases, but an individual need not fulfill all five factors to qualify as a minister. The remaining four factors must be evaluated on a case-by-case basis.
Five-Factor Test for Determining Ministerial Status, as Outlined in Wingo
A minister is someone who:
* Administers sacraments;
* Conducts worship services;
* Performs services in the "control, conduct, and maintenance of a religious organization";
* Is ordained, commissioned, or licensed; and
* Is considered a spiritual leader by his or her church or denomination.
Based on Wingo v. Comm'r, 89 TC 922, 1987.
The IRS no longer issues private letter rulings to answer the question of whether someone qualifies as a minister for federal tax purposes. Because the factors are applied differently in each case and the IRS has not provided definitive guidance, it is often difficult to ascertain if an individual qualifies as a minister. The courts have issued varying rulings, depending on the circumstances.
In Silverman v. Comm'r(57 TC 727, 1972), the Tax Court held that a Jewish cantor qualified as a minister, although not officially ordained. Since formal ordination is not required for commissioning in the Jewish faith, and the cantor performed religious duties within his congregation, the cantor was recognized as a minister for tax purposes. However, in Lawrence v. Comm'r (50 TC 494, 1968), the Tax Court ruled against the taxpayer, a minister of education in a Baptist church. Although he had a master's degree from a Baptist seminary, he was not an ordained minister and did not administer sacraments or preach at worship services and, thus, was denied minister status.
Special Tax Rules for Ministers
Tax benefits versus tax immunity. While ministers enjoy many tax benefits, they are not exempt from paying federal income taxes. The Supreme Court has ruled that requiring ministers to pay income taxes does not infringe upon their religious freedom guaranteed under the First Amendment (Murdock v. Pennsylvania, 319 US 105, 1943). Arguments by ministers in attempts to avoid income taxes are dismissed as frivolous by the IRS, and substantial penalties, back taxes, and interest may result.
Parsonage exclusion. Arguably the most significant tax benefit available to clergy is the ability to receive payments for living expenses tax-free. This is known as a "parsonage" or housing allowance. IRC section 107 states that amounts received by a minister for a parsonage or housing allowance are exempt from federal income tax. The concept of parsonage began about 100 years ago, when congregations provided housing as an incentive for clergy to come to their church (see "Clergy Present Special Opportunities and Challenges," by Laurence Dresner, Journal of Practical Estate Planning, June-July 2006, pp. 53-60). Because many congregations are only able to pay their ministers a low or modest salary, parsonage is a tool to provide much-needed compensation tax-free ("Tax Planning for Servants of God," by Frances E. McNair, Edward E. Milam, and Deborah L. Seifert, Journal of Accountancy, October 2004, pp. 65-69).
Historically, parsonage was only available in the form of actual housing provided to a minister by a congregation. Over time, laws were passed to expand this sizeable tax benefit to ministers who rent or own a home. Today, the concept of parsonage includes parsonage allowances, rental allowances, and housing allowances. Amounts received by ministers for parsonage are not deducted from income; rather, the amount is not included in their income.
The parsonage amount excludable from taxable income depends on the type of living arrangement. There are procedures that the church or organization must follow if an allowance is paid to the minister. Specifically, the church must designate the parsonage amount in an employment contract, in minutes of a business meeting, in its budget, or in other appropriate documentation [Treasury Regulations section 1.107-1(b)]. A definite amount must be designated at the beginning of each year, and it cannot be retroactive (see IRS Publication 517).
A minister who lives in a church-owned parsonage may exclude the fair rental value of the property from income for federal taxes. The minister may also exclude a designated allowance for utilities, maintenance, and furnishings to the extent of actual expenses incurred [IRC section 107(2)]. Similarly, a minister who rents a home may exclude a designated allowance for rent, utilities, and upkeep to the extent of actual expenses incurred.
Owning a home. A minister who owns his home and receives a housing allowance may receive additional benefits; thus, the rules for home ownership are more complex. As a homeowner, a minister may be eligible for a "double deduction." While property taxes and mortgage interest may be included in a designated housing allowance, these items may also be taken as itemized deductions on Schedule A (see Revenue Ruling 87-32, 1987-1 CB 131). Ministers should consider all of the expenses in Exhibit 2 when determining a housing allowance, as the allowance may be used to offset any of these expenses.
Checklist of Housing Allowance Expenses for Ministers Who Are Buying a Home
1. Homeowners association dues
2. Maintenance items (pest control, etc.)
3. Structural repairs/remodeling
4. Down payment on home
5. Mortgage payments and interest
6. Property taxes
7. Homeowner's insurance
9. Furnishings and appliances
10. Yard maintenance/improvements
Based on Revenue Ruling 87-32, 1987-1CB 131, and the Church & Clergy Tax Guide (2007), p. 233.
Concerning the housing allowance, a minister may exclude the least of the following (IRS Publication 517): 1) the amount actually used to provide a home (see items in Exhibit 2); 2) the amount designated as a housing allowance; or 3) the annual fair rental value of the furnished home. There is no limit to the amount of the housing allowance, as long as the proper procedures discussed above are followed. There may be some cases where the housing allowance represents nearly all of a minister's compensation, especially in areas where the cost of living is substantial. Adequate records and receipts should be sufficient in the event of an IRS audit. If the housing allowance exceeds actual usage or rental value, however, the excess must be reported as taxable income.
When determining the amount of the housing allowance, a minister should be diligent to accurately estimate living expenses for the upcoming year. If the designated housing allowance ends up being less than the actual expenses incurred, the exclusion from income is limited to the amount of the housing allowance. A poorly determined housing allowance may result in the forfeiture of significant tax benefits.
Determining fair rental value. The fair rental value of a home owned by a minister is the rental value of the furnished home plus utilities. Because the rental value limits the amount excludable for a housing allowance, an accurate rental value is extremely important. Neither the IRS nor Congress has provided a definitive method for determining fair rental value. The rental value should nevertheless be determined objectively, representing an arm's-length transaction between independent parties. One method is to ask a real estate professional to provide an informal opinion about the rental value of the home. The estimate is usually a range of values and should be written and signed by the agent to provide documentation in the event of an audit.
Congressional action. The concept of parsonage has seen strong bipartisan support in Congress. In 2002, an appeals court surprisingly questioned the constitutionality of housing allowances, even though the parties to the case did not raise the question of constitutionality [Warren v. Comm'r, 90 AFTR2d 2002-6058 (CA-9,2002)]. In 2002, Congress passed the Clergy Housing Allowance Clarification Act (P.L. 107-181) by a unanimous vote in both the House and Senate. The law amended the IRC to limit housing allowances to the fair rental value of the home, forcing the case in the appeals court to be dismissed.
Dual Tax Status
Whether a minister is classified as an employee or self-employed for federal tax purposes is primarily a determination of fact The IRS and the courts use a variety of tests to determine tax status. Three common tests include: 1) the common law employee test (IRS Publication 517); 2) the IRS 20-factor test (Revenue Ruling 87-41, 1987-1 CB 296); and 3) the Tax Court's seven-factor last (Weber v. Comm'r, 103 TC 378, 1994). While discussing each test in detail is beyond the scope of this paper, the Tax Court's seven-factor test is shown as an example in Exhibit 3. The factors include items such as the degree of control an employer possesses over a minister, the training or education required for the job, the full-time requirement, and the right of the employer to discharge the minister.
The Tax Court's Seven-Factor Test
To distinguish between employee and self-employed status, one must consider:
* Degree of control exercised by the principal over the details of the work (this is the most crucial test);
* Which party invests in the facilities used in the work;
* Opportunity of the individual for profit or loss;
* Whether the principal has the right to discharge the worker;
* Whether the work is part of the principal's regular business;
* Permanency of the relationship; and
* Relationship the parties believe they are creating.
Source: Weber v. Comm'r, 103 TC 378, 1994.
Upon application of these tests, most ministers will be considered employees for federal tax purposes. According to Laurence Dresner, there are several reasons why it is usually more beneficial for a minister to be classified as an employee rather than as a self-employed individual. First, certain fringe benefits, such as employer-paid health insurance premiums, life insurance premiums, and contributions to retirement accounts, may be excluded from taxable income. Second, ministers may be reimbursed for business expenses without an income tax effect as long as the reimbursements are part of an "accountable plan." Third, selfemployed individuals are subject to a greater risk of being audited. Finally, if a minister is audited and reclassified by the IRS as an employee, penalties and additional taxes will be assessed.
While most ministers are classified as employees for federal tax purposes, they are not subject to Social Security and Medicare taxes on their W-2 wages. Instead, ministers are considered self-employed for Social Security and Medicare tax purposes. For this reason, ministers are often said to have a dual tax status. In 2008, a minister would pay 12.4% Social Security tax on income up to $102,000, and 2.9% Medicare tax on all income. One-half of self-employment tax may be deducted on Form 1040 when computing adjusted gross income.
It is important to note that although they are excluded from income for federal tax purposes, parsonage or housing allowances are included in income when computing self-employment taxes. A common mistake made by tax preparers on ministers' returns is to exclude the housing allowance from self-employment income.
Business expenses. One negative aspect of being classified as an employee is that unreimbursed business expenses are reported on Schedule A and are subject to the 2% of adjusted gross income (AGI) floor. Of course, if a minister does not itemize, he will not receive any tax benefit from unreimbursed business expenses. In addition, if a minister receives taxexempt income, such as a parsonage or housing allowance, the expenses allocable to such income are not deductible [IRC section 265(a)(1)]. This is known as the Deason Rule (Deason v. Comm'r, 41 TC 465, 1964), and it requires ministers to reduce the deduction for unreimbursed business expenses by the percentage of income that is tax-exempt. Nevertheless, these expenses are fully deductible from self-employment tax. The Deason Rule does not apply to mortgage interest or real estate taxes on the minister's home.
Reimbursement plans. This drawback of employee status may be countered with a properly structured accountable reimbursement plan, that is, one which meets the following four requirements (see the subsections of Treasury Regulations section 1.62-2):
* The expenses must have a business connection. These expenses must be incurred by the minister while performing services as an employee of the organization.
* The minister must provide adequate accounting of the expenses to the employer within a reasonable amount of time, no more than 60 days after the expense is incurred.
* Any excess reimbursements must be returned to the employer within a reasonable amount of time, no more than 120 days after the reimbursement is paid.
* The reimbursements must be paid with the employer's funds and must not reduce the employee's salary.
Under a properly structured accountable plan, reimbursements are not included in taxable income. In contrast, in any nonaccountable plan, reimbursements must be included in taxable income.
Exempt from Federal Withholding
In most cases, employers are required to withhold federal taxes from wages paid to employees. Ministers classified as employees, however, are exempt from federal withholding only with respect to wages earned for "services performed in the exercise of their ministry" [IRC section 3401(a)(9)]. Such services, as noted above, include ministration of sacerdotal functions, conducting religious worship services, and control and maintenance of religious organizations under the authority of a church or denomination [Treasury Regulations section 1.1402(c)-5(b)(2)].
Because they are exempt from withholding, ministers pay estimated taxes in quarterly installments. They may voluntarily elect to have federal taxes withheld from their W-2 wages, which is often considered preferable to estimated tax payments. Voluntary withholding also lessens the quarterly or year-end tax liability and reduces the chance of incurring penalties for underpayment of taxes.
Self-employment wages. While ministers are exempt from withholding for federal income taxes, they are still responsible for making estimated payments of self-employment tax. Rather than paying estimated self-employment tax, ministers may indicate--on Form W-4, line 6-an additional amount to be withheld from their wages to offset self-employment tax liability.
Often, ministers perform services such as baptisms, weddings, and funerals, for a fee paid directly to the minister. Such fees are considered self-employment income to the minister. This income is also not subject to withholding and is reported on Schedule C.
Wages not in the "exercise of ministry." Sometimes, ministers may work a secular job in addition to their duties as religious leaders. Wages earned outside the "exercise of ministry" are not exempt from federal withholding. In fact, none of the special tax rules for ministers apply to wages earned from secular occupations.
Exemption from Self-Employment Tax
Ministers may request an exemption from self-employment tax by filing Form 4361-Application for Exemption from Self-Employment Tax for Use by Ministers, Members of Religious Orders and Christian Science Practitioners--with the IRS. The basis for the request must be that the minister is conscientiously opposed to, or because of religious principles is opposed to, accepting public insurance. The request may not be made for economic reasons. A letter explaining the reasons for requesting an examption may be filed in lieu of Form 4361, and the request is subject to IRS approval.
Form 4361 must be filed by the due date for the tax return for the second tax year in which net earnings from self-employment are at least $400 [IRC section 1402(e)(3)]. Approval may take as long as nine months. Typically, once the exemption is granted by the IRS, it is irrevocable [IRC section 1402(e)(4)]. Even if a minister is exempt from paying self-employment taxes, he may still be eligible to receive retirement benefits based on the coverage of his spouse from the spouse's performance of nonministerial services. In addition, a minister who opted out of Social Security may purchase Medicare insurance after age 65 (see Richard R. Hammar, Church & Clergy Tax Guide, Christianity Today International, 2007, p. 458).
Example: Untimely Filing. William Bennett was the senior pastor of Neenach Bible Church. Bennett reported ministerial income of $400 or more in 1997-1999 and 2001-2002. He paid self-employment taxes of $4,191 in 1998. Each year, Bennett filed Form 4361, or a letter in lieu of the form, with his tax return. In 2003, the IRS sent Bennett a letter indicating that the Form 4361 filed with his 2002 tax return was untimely and that the due date for filing the form was April 15, 2001. Accordingly, the IRS denied his request for exemption from self-employment tax.
Bennett claimed that he filed a Form 4361 that was approved by the Service in or around 1980. He claimed that, even if the IRS did not receive the Form 4361, the IRS should be held to the April 15, 2001, due date indicated in the 2003 letter. Therefore, he argued that the Form 4361 filed with his 1999 return on April 15, 2000, should be considered timely.
The Tax Court (Bennett v. Comm'r, TC Memo 2007-355, 2007) found no evidence that Bennett properly filed a Form 4361 in 1980. The court held that, although the IRS's letter indicated the due date for a timely Form 4361 was April 15, 2001, the correct due date was April 15, 1999, because Bennett received more than $400 in self-employment income in 1997 and 1998. The fact that Bennett paid self-employment tax for 1998 weakened his claim that he believed he was exempt from self-employment tax. The court held that the Forms 4361 and letters filed with Bennett's 1997 through 2002 returns were all either untimely or lacked supporting documentation and therefore were not approved by the IRS. Bennett's 2002 ministerial income was not exempt from self-employment taxes.
Other Tax Snares to Avoid
Example: Tithing Expenses. Bradley Pixley was an ordained Baptist minister. In 2000, the IRS sent Pixley and his wife a notice of intent to levy regarding unpaid tax liabilities of $19,367 for 1992 and $39,851 for 1993. The Pixleys requested a due process hearing and submitted an offer in compromise. On Form 433-A, Collection Information Statement for Individuals, they listed a $520 "tithe to church" as a necessary monthly living expense. In the hearing, the IRS officer requested multiple times that Pixley provide evidence of his ministerial status and the fact that the tithe was a condition of his employment. Pixley failed to provide the necessary evidence, so the IRS disallowed the tithing expenses and determined that the Pixleys were able to fully pay the taxes in question.
The Pixleys petitioned the Tax Court, alleging that the disallowance of the tithing expenses violated their First Amendment right to free exercise of religion. The court ruled in favor of the IRS, stating that tithing expenses a minister is required to pay as a condition of employment are allowed as necessary expenses in determining the ability to pay taxes (Pixley v. Comm'r, 123 TC 269,2004). In this case, however, Pixley failed to provide evidence that he was a minister or that the tithes were required. The court stated that contributing to religious organizations is a common burden on all taxpayers' pocket-books, not a burden on their free expression of religion. The court allowed the IRS to proceed to collect the unpaid taxes by levy.
Example: Trusts. A Catholic priest, Father Tamulis, died in 2000, leaving most of his $3.4 million estate to a living trust. The trust was to continue for the longer of 10 years or the joint life of Tamulis's brother and his brother's wife, who had a life estate in a home owned by the trust for which the trust paid the real estate taxes. The net income was to be paid to Tamulis's two grandnieces, less $10,000 to be paid annually to a third niece until she graduated from medical school. Upon termination of the trust, the assets would be paid to a Catholic diocese.
The executor of Tamulis's estate took a deduction of $1.5 million in order to represent the present value of the charitable remainder. The trust instrument did not specify a percentage of the trust's fair market value to be paid to the noncharitable beneficiaries to qualify as a charitable remainder unitrust (CRUT), nor did it specify a fixed dollar amount to be paid to noncharitable beneficiaries to qualify as a charitable remainder annuity trust (CRAT). The IRS disallowed the deduction because the trust did not qualify as a CRUT or CRAT under IRC section 2055.
To remedy this type of situation, the trust may be reformed by filing a judicial proceeding within 90 days after the due date of the estate tax return. For some unknown reason, the proceeding was never filed by the executor of Tamulis's estate. The executor presented a proposed reformation to the income beneficiaries, but one niece did not sign it. The executor managed the trust as if it were a qualified unitrust under section 2055. The issue before the Seventh Circuit Court of Appeals was whether the management of the trust as a qualified unitrust should be considered in substantial compliance with the IRC [Estate of Tamulis v. Comm'r, 2007-2 USTC para. 60,553 (CA-7, 2007)].
The court noted that the trust did not qualify as a CRUT or CRAT at the time of Tamulis's death but could have been reformed in order to qualify. However, no action was taken to specify the amounts to be paid to the noncharitable beneficiaries, nor was action taken to reform the trust. In order to qualify for substantial compliance, a taxpayer must have "had a good excuse (though not a legal justification) for failing to comply with either an unimportant requirement or one unclearly or confusingly stated in the regulations or the statute." Tamulis's trust flunked this test--the executor, knowing a substantial deduction was at stake, had no excuse for failing to take the proper steps to reform the trust. The Seventh Circuit Court of Appeals affirmed the decision of the Tax Court and ruled that the trust did not qualify as a CRUT from substantial compliance; therefore, the estate was disallowed the deduction.
Understanding the Benefits and Ethical Requirements
A call to the ministry is an exhilarating experience. When an individual surrenders himself to vocational ministry, he is assuming great responsibility. A minister should serve as an exemplar to others and possess the utmost level of character and moral conduct.
Unfortunately, some people wish to become ministers solely for personal gain, including capitalizing on favorable tax rules. Some individuals possess "mail-in" credentials or complete an online "ordination" process in an attempt to be classified as a minister for federal tax purposes. On the other hand, legitimately ordained ministers often seek to exploit their tax status for illegal gain. A few years ago, a minister claimed he was not liable for income taxes because he was not a citizen of the United States but, rather, of "the place I intend to eventually and permanently reside, which is heaven." Furthermore, he claimed that he received no wages but that he and his family were "supernaturally provided for by the Lord Jesus Christ through the unsolicited freewill love offerings of others" [McGugan v. Katzmar, 96 AFTR2d 2005-7182 (DC NJ, 11/14/2005)]. Needless to say, the IRS dismissed these arguments as frivolous, and the court agreed.
A career as a minister can be a rewarding and meaningful one overall, but most do not heed the calling fully aware of the tax implications. As described above, the tax laws contain special rules applying strictly to ministers that are complex and often are applied differently on a case-by-case basis. Many ministers are unaware of the special tax rules applicable to them or are misinformed about how the rules apply. It is crucial that ministers understand the tax benefits available to them and the requirements they entail. A knowledgeable CPA can help ministers to understand the laws and receive maximum tax benefit from their occupation.
Ted D. Englebrecht, MBA, MAcc, PhD, is the Smolinski Professor of Accounting, school of accountancy, college of business, Louisiana Tech University, Ruston, La. Jonathan A. Cameron, MPA, is a staff accountant at John D. Cameron & Co., CPAs, Monroe, La.
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|Title Annotation:||federal taxation|
|Author:||Englebrecht, Ted D.; Cameron, Jonathan A.|
|Publication:||The CPA Journal|
|Date:||Sep 1, 2008|
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