Why clergy returns can get complicated
Completing a return for a “minister of the gospel” can be a mess of biblical proportions without a full understanding of how these special taxpayers are treated
Par·son·age/n. (15 c.) 1. The house provided by a church for its pastor
Since biblical times, religious institutions and parsonages have held a special exempt tax status (see Genesis 47:26). This tradition still applies today to ministers, rabbis, priests, and clergy, regardless of denomination.
When it comes to completing the tax return, properly classifying clergy income, calculating credits, and reporting expenses aren’t always simple. Many taxpayers and tax professionals are surprised by the complexity of preparing clergy returns. Here, we’ll explore why.
Clergy can be treated as self-employed and as employees
Let’s start with a few definitions. The tax code doesn’t define church, but does attribute to it certain characteristics, such as having a recognized form of worship and a formal code of doctrine.
The tax code broadly defines clergy, or ministers, as individuals who are duly ordained, commissioned, or licensed by a religious body constituting a church. Ministers can perform “ministerial duties,” such as conducting religious worship.
For tax purposes, the IRS treats clergy in two ways:
Under statutory law where ministers are treated as self-employed, ministers will owe a 15.3 percent self-employment tax on:
- Cash housing allowances, or the fair rental value of a parsonage provided to them
- Income they earn from performing qualified ministerial services
Churches aren’t required to withhold income taxes from payments to ministers for qualified services, although ministers can voluntarily withhold taxes using Form W-4. Ministers will owe income tax and self-employment taxes on wages they earn for qualifying ministerial services. Ministers should make estimated tax payments if they believe they will owe taxes at the end of the year.
This is true unless the minister is retired, or if the minister files and receives an exemption from self-employment tax with Form 4361, Application for Exemption From Self-Employment Tax for Use by Ministers, Members of Religious Orders and Christian Science Practitioners. If the minister files Form 4361 and receives an exemption, the minister is stating that that he or she should be exempt from paying into the U.S. Social Security system based on religious opposition to government-provided retirement assistance.
For all other tax purposes, most clergy members are employees under the common-law rules. For example, churches must send a Form W-2 reporting the minister’s income and housing allowance or fair rental value of their parsonage (Box 14), but with no Social Security and Medicare (FICA) withholding. Ministers report unreimbursed expenses on Form 2106 and Schedule A (subject to a 2 percent floor of adjusted gross income), just like all employees.
One of the world’s oldest income exclusions is still causing headaches today
A special income exclusion applies only to ordained, active and retired ministers. It allows churches to provide ministers with a rent-free home or a housing allowance. The minister can then exclude either the fair rental value of the home or the cash housing allowance from his or her taxable income for the year. In that case, the minister would owe only self-employment taxes (and not federal income taxes) on the allowance, unless he or she opted out by having an approved Form 4361. To sweeten the deal, once a minister retires, he or she is no longer subject to self-employment tax on those amounts.
This exclusion can lead to pitfalls on ministers’ tax returns. For example, churches may try to retroactively designate the housing allowance, provide ministers with more than a “reasonable” allowance, or give ministers a second home – all of which aren’t allowed. Here are the details of how to avoid some of the most common mistakes.
For ministers to exclude housing allowances from their taxable income, churches must officially designate the payments as a housing allowance and document the amount of the allowance before paying the minister.
Likewise, if the minister is retired, the church must designate part of his or her pension as a housing allowance before payment. Usually, the church and the minister sign a written agreement or add a note to the church’s meeting minutes to define the terms of the agreement. There are several caveats that come with the exclusion:
- The minister can exclude the allowance only if he or she actually rents or lives in the home.
- The minister can exclude the allowance only up to the fair rental value of the home. Fair rental value includes the home, furnishings, certain home features (such as a garage), and the cost of utilities.
- The amount must not be more than reasonable pay for services rendered.
If a minister receives a housing allowance on a home that is fully paid for, the minister will owe income tax and self-employment tax on any allowance that’s more than the amount actually used to provide the home. Generally, those expenses include rent, mortgage interest, real property taxes, utilities, repairs, and other expenses directly related to providing a home.
Ministers can exclude from their gross income the fair rental value of a parsonage. However, the IRS hasn’t provided further guidance on what qualifies as “fair rental value” for these purposes. This exclusion often proves less helpful for ministers whose churches provide them with a home, because they must pay self-employment tax on the fair rental value (including utilities) of the home, but don’t have much guidance on how much they should be able to exclude. Ministers living in a parsonage may also receive an excludable housing allowance for furnishings and utilities if a designation was made before they used the home.
To further muddy the waters, even though ministers’ housing allowances are included in their self-employment income, they don’t report their ministry expenses on Schedule SE. Instead, they report their expenses on Form 2106 and Schedule A (Form 1040), subject to a floor of 2 percent of adjusted gross income (AGI).
Calculating the EIC and the ACTC
Things get even more complicated if ministers want to claim a tax credit such as the earned income tax credit (EIC). For some tax purposes, ministers should include their housing allowances in their gross income, and for other tax purposes, they should exclude their allowances.
Determining when to include a minister’s housing allowance in the calculation for tax credits depends on whether the minister is:
- Active: Active ministers will exclude the housing allowance from income tax, but not self-employment tax. However, if they are employees, they will include the allowance in their AGI when calculating the EIC, but not the additional child tax credit (ACTC).
- Active with an approved exemption (Form 4361), or retired: Ministers with an approved exemption and retired ministers will exclude the housing allowance from their income and self-employment taxes. They will also exclude the housing allowance from their AGI when calculating the EIC and the ACTC.
Other income and the ACA
As described, if ministers perform qualifying services in the exercise of ministry, they will owe income taxes and self-employment taxes unless they're exempt from self-employment taxes (Form 4361). Additionally, all “love offerings” and fees for marriages, baptisms, funerals, etc., are subject to income tax. Whether these offerings are further subject to FICA or SECA tax depends on whether the minister performs these activities as an employee or as a self-employed individual.
Any income a minister earns outside of the ministry is subject to income taxes and FICA taxes, if the minister is an employee of the nonreligious entity that pays him or her. Likewise, self-employed work outside of the ministry is subject to SECA. No exemption on Form 4361 will apply to these activities.
Finally, note that when calculating the premium tax credit (PTC) for the Affordable Care Act, modified adjusted gross income doesn’t include housing allowances or rental value of a parsonage. The statute specifically names additions to gross income for PTC purposes, and the statute doesn’t list a minister’s housing allowance as one of the required additions.
Many ministers benefit from a tax specialist’s help
Clergy returns, while enjoying special status, also come with a special set of considerations. The duality of a minister’s tax treatment requires tax professionals (or sometimes an unpaid volunteer church accountant) to determine the amount of so-called “tax-free” income the minister received and then reduce the amount of allowable deductible expenses accordingly. That’s after determining how much of the minister’s housing allowance is excludable from gross income with nearly no guidance on what expenses qualify for deduction.
That’s why many of these taxpayers turn to a professional who can help them separate their income into the correct categories, apply for exemptions, and properly calculate important tax credits.