Tax-free housing allowances for ministers: documentation is critical to ensure exclusion.
The Tax-Free Allowance
Under Sec. 107, gross income of a minister does not include:
1. The rental value of a home furnished to him as part of his compensation; or 2. The rental allowance paid to him as part of his compensation, to the extent used to rent or provide a home.
Thus, the use of a house can be provided, or a cash housing allowance for the minister to rent or purchase a home. An allowance continues to be tax free when paid to the minister after retirement, but the exclusion is not available for payments to the minister's surviving spouse.
Qualifying for a Parsonage Allowance
Under Regs. Sec. 1.107-1(a), the parsonage allowance is tax free if provided as remuneration for services that are ordinarily the duties of a minister of the gospel. Although neither Sec. 107 nor the regulations provide a definition of "minister," Regs. Sec. 1.107-1(a) indicates that Regs. Sec. 1.1402(c)-5, which defines a minister for self-employment (SE) tax purposes, applies for Sec. 107 purposes. Under Regs. Sec. 1.1402(c)-5(a)(2), a minister is one who is "duly ordained, commissioned, or licensed" as a minister of a church. The Tax Court stated in Wingo that a minister may be either ordained, commissioned or licensed, but need not be all three.
The parsonage allowance is available for ministers in all religious faiths. Regs. Sec. 1.107-1(a) provides that the duties of a minister include the following:
1. The performance of sacerdotal functions (e.g., weddings, baptisms, Lord's Supper, Bar Mitzvahs, funerals, etc.). 2. The conduct of religious worship. 3. The administration and maintenance of religious organizations and their internal agencies. 4. The performance of teaching and administrative duties at theological seminaries.
The parsonage allowance is excluded for income tax purposes, but is subject to SE tax unless the minister elects to be excluded from Social Security coverage. In Wingo, Rev. James Wingo, a probationary member of the United Methodist Church, an ordained deacon and a licensed local pastor of a church of that denomination, filed an election on Form 4361, Application for Exemption from Self-Employment Tax for Use by Ministers, Members of Religious Orders and Christian Science Practitioners, to be exempt from SE tax; the election was rejected as filed late. Wingo then attempted to avoid paying SE tax by showing that he was not a minister. The Tax Court considered the first three factors listed above and the following two additional factors in determining if Wingo was a minister:
1. The person is ordained, commissioned or licensed, and 2. The congregation considers him a religious leader or minister.
The court determined that Rev. Wingo was a minister and, thus, liable for SE tax.
Under Silverman, an individual can qualify as a minister if he participates in some of the sacerdotal functions - it is not necessary for the individual to participate in all of them. Thus, if the church has more than one minister, their job descriptions should refer to them as "ministers of the gospel," and state that they are expected to perform any sacerdotal function needed.
Limits on the Allowance
There is no dollar limit or percentage of income limitation on the parsonage allowance. However, as seen in Table 1, above, the tax-free allowance is the least of (1) the actual amount spent on housing, (2) the amount designated by the church or (3) the rental value of the home.
Table 1: Excluding the Parsonage Allowance
Mortgage principal, interest, taxes and home insurance
Cost of furnishings
Cost of utilities
Other housing costs (excluding food and domestic help)
1. Total actual housing costs
2. Housing allowance designated by the church
3. Rental value of the house (furnished) plus utilities
Tax-free housing allowance (smallest of 1, 2 or 3)
When the taxpayer uses a housing allowance to purchase a home, the third limit applies; thus, the taxpayer may not exclude more than the fair rental value of the home acquired. This includes the fair rental value of the home, furnishings and appurtenances (e.g., a garage), and the cost of utilities. The exclusion is limited to the value of services provided when the allowance represents excessive compensation for the services provided by the minister.
In Marine, Rev. Fred Marine sold one house and purchased another. He had the church designate all of his compensation as a parsonage allowance. Less than 10% of his compensation was actually used to purchase the new house; the balance came from the sales proceeds of the first house. The Tax Court allowed him to exclude the maintenance costs of both residences, plus the actual amount of the parsonage allowance that was applied toward the purchase of the second residence.
Designation of the Allowance
Under Regs. Sec. 1.107-1(b), the designation of an amount as a rental allowance may be evidenced in:
* An employment contract. * Minutes. * A resolution. * A budget. * Any other appropriate instrument evidencing official action.
The designation must be made prior to the payment and is sufficient if it permits a payment or a part thereof to be identified as a payment of rental allowance (as distinguished from salary or other remuneration).
If an allowance is determined to be inadequate, there are no provisions for retroactive revision. However, an inadequate allowance can be "amended" and increased for the remaining portion of the year.
The organization should consider overestimating the allowance amount to allow for unexpected expenses and increased costs. If actual out-of-pocket expenses are less than the amount designated, it is the minister's responsibility to report the excess as income.
Warnke involved a self-employed evangelistic minister who preached at churches throughout the country. His earnings came from offerings and tape sales. The Tax Court held that, because neither an employing church nor another qualified organization designated a portion of his income as a parsonage allowance in advance, none of his income qualified for the Sec. 107 exclusion. The taxpayer's commitment to making mortgage payments was insufficient, as the designation had to be made by a third party.
Thus, a traveling minister should have each church designate a portion of the compensation as a housing allowance.
In Letter Ruling 8511075, the church minutes specified the housing allowance for 1982. There was no evidence of official action by the church in 1983 relative to the allowance. In 1984, the church made a retroactive designation of the allowance for 1983. The IRS determined that the retroactive designation was not effective, and the allowance for 1983 was fully taxable.
The regulations are silent as to whether the designation must be in writing; however, prior oral designation has been deemed sufficient. In Kizer, the board of directors discussed a housing allowance when hiring the minister, and determined that his compensation would include a housing allowance; however, the allowance was not recorded in the minutes. The Tax Court stated that the designation need not be in writing as long as there is satisfactory proof of official action designating the allowance. It determined that there was satisfactory evidence to support the allowance.
The court then determined the allowance to be $6,250, the amount that the minister had received as a housing allowance at his prior position, because the recording secretary, who kept the church's minutes, testified that the minister was to receive the same allowance as in his prior position. The minister was not permitted to exclude the full amount of such allowance because his records showed that actual housing expenditures were less than the allowance. This case is a reminder that it is critical to be able to prove that a designation was made, and to have expense records showing that the full allowance was actually spent on housing costs.
Expenses Covered by the Allowance
The housing allowance must relate to a dwelling place (including furnishings) and appurtenances (e.g., a garage). Under Regs. Sec. 1.107-1(c), the exclusion is allowed when the allowance is expended for (1) renting a home, (2) purchasing a home and/or (3) costs related to providing a home. Further, expenses for food and servants are not directly related to providing a home. When the minister rents, purchases or owns a farm or other business property in addition to a home, the portion of the rental allowance spent in connection with the farm or business property is not excluded from income.
In Letter Ruling 9115051, a minister received a housing allowance of $1,000 per month, which he used for a monthly mortgage payment. The minister sold the home, and used the net proceeds to purchase a smaller one. The minister continued to receive the housing allowance, but no longer made mortgage payments. The IRS ruled that, because the minister was no longer using the allowance to make mortgage payments, it was no longer tax free. The IRS also ruled that payments on a home equity loan do not qualify, and that taking out a loan secured by the home would not create mortgage payments qualifying for the allowance.
Effect on Retirement Plans
Normally, all compensation received by a self-employed person can be used in computing contributions to a Keogh plan. However, a minister may be subject to a special rule. Compensation received by a minister is not considered SE income for Keogh plan purposes, if he meets the common-law definition of an employee. The minister can, however, make contributions to a Keogh plan from SE income received for weddings and other extra services.
A minister who is a common-law employee may participate in an employer-sponsored retirement or annuity plan. The minister may also provide for retirement by establishing an individual retirement account, subject to the normal limits applicable to those plans.
In Rev. Rul. 73-258, a religious organization's retirement plan paid retired ministers 1% of compensation for each year of service (up to 30 years). The issue was whether the housing allowance was compensation in computing the annual retirement benefit. The IRS determined that even though the housing allowance is excluded from gross income, it is compensation for purposes of computing retirement benefits.
Effect on SE Tax
Churches are exempt from income tax under Sec. 501(c)(3), but are covered by the Social Security Act under Sec. 3121(w) unless they elect not to be covered. Under Sec. 3121(b)(8)(B), a church employee's wages are subject to FICA if the church has not elected to avoid coverage. A church employee who is not a minister is not subject to SE tax on compensation received from the church.
Under Sec. 1402(a)(8), ministers are considered self-employed for SE tax purposes, and a parsonage allowance is included in SE income. The church may provide an allowance or reimbursement for the minister's income or SE tax; however, the minister must report this payment as additional gross and SE income.
Sec. 1402(e) provides that ministers may elect to be exempt from SE tax by filing Form 4361; under Sec. 1402(e)(3), this form is due no later than the due date of the return for the second year in which the minister has at least $400 of SE income, any part of which is derived from services as a minister.
Preparing the W-2 and Form 1040
Compensation of a minister, other than the housing allowance, is reported as wages in Box 1 on Form W-2. Box 3 on Form W-2, Social Security wages, is left blank.
Regs. Sec. 31.3402(p)-1 provides that a minister may enter into an agreement with the church to have Federal income tax withheld. In such case, withholding is reported in Box 2, Federal income tax withheld. Voluntary withholding may eliminate the need for estimated tax payments. The housing allowance is indicated in Box 14 ("Other") on Form W-2.
The minister's wages from a church are reported on Form 1040, line 7, along with wages from other sources. Amounts received for weddings and similar services are reported on Schedule C. SE income includes the ministerial salary on line 7, net income from Schedule C, and the housing allowance. See Table 2, above, for various types of compensation and how they must be reported.
Table 2: Reporting Ministerial Income on Form 1040 Include Include in in income SE income
Ministerial salary Yes Yes
Fees for weddings, etc. Yes Yes
Parsonage allowance No Yes
Under Sec. 265(a)(6), a minister who purchases a home can deduct interest and taxes related to the home, even though those costs are paid for with the parsonage allowance.
Business deductions are subject to the general rules regarding nondeductibility of expenses related to tax-free income. Under Sec. 265(a)(1), no deduction is allowed for expenses to the extent they are allocable to tax-exempt income. However, the housing allowance is not excluded from SE income; thus, business expenses incurred by a minister are fully deductible in computing net SE earnings.
The result is different when computing taxable income. In McFarland, the minister owned a home. For 1988, the church provided him a $12,285 parsonage allowance; his other ministerial income that year was $27,300. He deducted telephone expense, auto expense, dues and other expenses on Schedule C. The Tax Court found that 31.03% ($12,285/$39,585) of his total income consisted of tax-free income; thus, 31.03% of his expenses were not deductible. This controversy did not involve the deductibility of mortgage interest and property taxes. In most cases, the minister is an employee, so that unreimbursed business expenses are deductible as miscellaneous itemized deductions, subject to the 2% floor.
The above rules and restrictions make it clear that the church has recordkeeping responsibilities if the parsonage allowance is to be tax free. The church should:
1. Prepare job descriptions for all ministers and other religious leaders who receive compensation. 2. Determine who qualifies for a housing allowance. 3. Determine the amount that qualifies as a tax-free allowance. 4. Obtain the board of directors' or other committee's approval as to the allowance. 5. Record the action regarding allowances in the official minutes. 6. Provide a written statement to each minister identifying the compensation designated as an allowance. 7. Remind ministers to maintain detailed records of expenditures related to the allowance.
 Rev. Rul. 75-22, 1975-1 CB 49.  James S. Wingo, 89 TC 922, (1977). The coordination, commissioning or licensing need not come from a higher ecclesiastical authority; it can come from the congregation itself. Abraham Salkov, 46 TC 190, 196 (1966).  The allowance is also available for a qualified minister providing services as an employee of the U.S., the District of Columbia,or a State, Territory, possession or political subdivision, but not for chaplains serving as commissioned officers in the Armed Forces (who qualify for military housing allowances).  The phrase "ordained, commissioned or licensed" is used to exclude self-appointed ministers. See Wingo, note 2, 89 TC at 938.  David Silverman, 57 TC 727 (1972).  Rev. Rul. 71-280, 1971-2 CB 92.  Rev. Rul. 78-448, 1978-2 CB 105.  Fred B. Marine, 47 TC 609 (1967).  Reverend Michael A. Warnke, 641 F Supp 1083 (E.D. Ky. 1986)(58 AFTR2d 86-5474, 86-2 USTC [paragraph]9570).  IRS Letter Ruling 8511075 (12/19/84).  Kerry L. Kizer, TC Memo 1992-584. See also Melvin L. Libman, TC Memo 1982-377 (oral designation of religious organization on behalf of ordained rabbi meets Regs. Sec. 1.107-1(b)'s requirements).  IRS Letter Ruling 9115051 (1/16/91).  Rev. Rul. 73-258, 1973-1 CB 194.  Rev. Rul. 80-110,1980-1 CB 190.  Robert M. McFarland, TC Memo 1992-440.  Michael D. Weber, 103 TC 378 (1994).
|Printer friendly Cite/link Email Feedback|
|Publication:||The Tax Adviser|
|Date:||May 1, 1995|
|Previous Article:||Income in respect of a decedent: minimizing the double taxation.|
|Next Article:||IRS follows AICPA position in guidance on proceeds received for homes and contents destroyed by disasters.|