September 29, 2009

Ministerial Tax Status: Let Me Out!

Question:

An individual who has previously been employed by a church as a non-ministerial employee now has been added to the church staff as an ordained minister. He finds that his tax situation is worse now. How could this happen? Let me out!

Answer:

This question has a lot of variables. I'll try to get right to the point.

As a non-minister, his full compensation was subject both to federal and state income taxes and to FICA tax withholding of 7.65 percent. The church was required to pay the other 7.65 percent of his social security and Medicare tax. These withholdings were mandatory.

As a minister, he now qualifies for a housing allowance which is free of federal and state income taxes. However, he is now considered self-employed (SE) for purposes of his social security and Medicare tax obligations. He is responsible for the full 15.3 percent SE tax on his income including the housing allowance. According to the Internal Revenue Code, withholdings are optional for him, but without a substantial amount of federal income tax withholding (enough to cover both his actual federal income tax and his SE tax) he must file and pay quarterly estimated tax payments on his own. Otherwise, he may owe a substantial balance due on April 15th.

What strategies have ministers and churches pursued to manage this cost?
1. Many churches recognize that they are saving the 7.65 percent normally the responsibility of employers. Accordingly, they increase his pay by 7.65 percent, then immediately withhold an identical amount as federal income tax so that his tax bite is partially shared.
2. Some ministers choose to opt out of the social security system (Form 4361).
3. If he has children, it may be that his housing allowance reduces his taxable income to the point of qualifying for tax credits that he may not have otherwise earned.
4. Others utilize other tax saving strategies such as 403(b) plans, HRA plans, and professional expense reimbursement plans (all subjects of previous postings to this blog).

Parsonage as Only Compensation

Question:

A church is looking to bring on a youth minister but is unable to offer compensation other than living arrangements in a church home. The minister is not ordained. Can housing be offered as the sole compensation? Would the person need to be hired as a regular employee or as an independent contractor? How would the church and the youth minister report this?

Answer:

Regardless of the ordination, licensure or other formal recognition of the minister, he will qualify for ministerial status as long as he is providing what the IRS calls sacerdotal (ministerial) duties for a qualifying church. Licensure, at a minimum, certainly helps to establish (or document, if necessary) his call to the gospel ministry. Generally, an ordained minister performing solely non-ministerial duties does not qualify for clergy tax status.

While the minister in this case will most likely be properly classified as an employee, he will not be issued Form W-2 because he has received no taxable compensation. He will be responsible to report the fair rental value of the parsonage as self-employment income on Schedule SE. He will be able to reduce this amount by any unreimbursed employee business expenses he incurred.

September 27, 2009

Missionary Furlough: Deductible Travel Expenses

Question:

Most commonly, mission agencies treat their missionaries as Form W-2 employees (and, I believe, properly do so). They classify disbursements to them in categories such as cash compensation, housing allowance, and reimbursable employee business expenses.

The question has been asked, "Are there any IRS restrictions to consider in a mission agency's policy for the quantity of trips back to the home country? Because long-term missionaries are employees and eligible for accountable expense reimbursement arrangements, a common practice is to classify travel costs for furlough leave as reimbursable business expenses."

Answer:

This question is addressed by IRS Publication 463. The Publication asks the question, "What Travel Expenses Are Deductible?" then answers it:

"Once you have determined that you are traveling away from your tax home [the foreign mission location, in most cases], you can determine what travel expenses are deductible. You can deduct ordinary and necessary expenses you have when you travel away from home on business. The type of expense you can deduct depends on the facts and your circumstances.

"If a spouse, dependent, or other individual goes with you on a business trip, you generally cannot deduct his or her travel expenses. You can deduct the travel expenses of someone who goes with you if that person: (1) is your employee, (2) has a bona fide business purpose for the travel, and (3) would otherwise be allowed to deduct the travel expenses.

"If a business associate travels with you and meets the conditions in (2) and (3) above, you can deduct the travel expenses you have for that person. A business associate is someone with whom you could reasonably expect to actively conduct business. A business associate can be a current or prospective (likely to become) customer, client, supplier, employee, agent, partner, or professional advisor. A bona fide business purpose exists if you can prove a real business purpose for the individual's presence. Incidental services, such as typing notes or assisting in entertaining customers, are not enough to make the expenses deductible."

In the case of a missionary family, my experience is that both spouses are expected to represent the ministry of the family. Whether the children's presence is "ordinary and necessary" (using the IRS definition) must be determined based on the facts and circumstances of the situation.

There is no maximum number of trips that the IRS will permit. Rather, deductibility is determined based on the above criteria. A missionary returning to the US simply to "drop off" his college student at school seems to fall short of the criteria. At the opposite extreme, doing so during an extended furlough of reporting to churches should only deny deductibility for the excess expenses incurred related to the personal nature of the college trip (i.e., extra mileage, meals and lodging will not be deductible).

September 26, 2009

Designated Funds: Liability or Equity accounts?

Question:

A recent question came up on how certain designated funds should be reported on our balance sheet – we have funds like benevolence, scholarship, etc. – a previous treasurer changed these accounts from liability to equity and now we have another individual saying that these accounts must be liabilities; any recommendations on which way is correct?

Answer:

Unless the ministry is undergoing a certified audit or otherwise committed to strictly following Generally Accepted Accounting Principles (GAAP), I believe the classification is irrelevant. The key point is that the unspent balances will be carried over from one fiscal year to the next.

For us accountants:
Technically, the accounts are equity accounts in not-for-profit organizations following FASB 116,  which stipulates this treatment in order to comply with GAAP.

September 18, 2009

100% of Compensation Designated as Housing Allowance

Questions:

Are both full- and part-time pastors considered as employees who receive year-end earnings Form W-2? Can 100% of their pay be designated as housing?

Answers:

All church employees should receive Form W-2 regardless of their full- or part-time status. Form 1099-MISC is reserved for reporting independent contractor compensation only. Common examples of independent contractors compensated by church include janitorial services and guest speakers.

The housing allowance is limited to the lesser of three amounts: a) the amount actually used to provide a home, b) the amount designated by a minister's employer, c) the fair rental value plus actual cost of utilities. It may be that a minister expects a) and c) to exceed his full cash compensation, especially if he is part-time. Accordingly, a 100% designation may be appropriate.

Both full- and part-time ministers are eligible for the full list of allowable employee business expense deductions reportable on Form 2106. See the Form 2106 instructions for more information.

Payments to Former Pastor

Question:

A church sets up a fund to pay a former pastor's nursing home, housing and other expenses. He and his wife are current members of the church. Is the church required to issue him a Form 1099-MISC (or Form W-2)? Is there a limit as to how much he can receive?

Answer:

Situations such as this are common. Typically, the church has been unable to compensate the former minister as well as it would have wished and now intends to provide some current support to address this undercompensation. Such payments to the minister or on his behalf are taxable as compensation. The church can designate a portion to housing allowance and the minister may elect Internal Revenue Code section 403(b) elective deferrals which may reduce the tax bite.

There is no limit to the amount other than possible Social Security retirement limitations on those who have not reached full retirement age (between age 65 and 67 or so).

Another possible motivation for these payments produces an entirely different tax effect. Just as any member of a congregation may have needs addressed by the church's benevolent fund, a minister who is a current member may receive non-taxable benevolent gifts. Such gifts are not motivated by past undercompensation, but by compassion for the needs of members as funds are made available to cover them.

The IRS expects the church to determine the tax reporting (or absence of it) based on the full facts and circumstances of the case.

Housing Allowance and Form 1099-MISC Reporting

Question:

A church provides its minister a housing allowance, but for other purposes it believes that it must report the full amount of compensation (including the non-taxable housing allowance portion) on Form 1099-MISC (in order to demonstrate the full earnings of the minister). If the church reports his compensation, including the housing allowance, on Form 1099-MISC as taxable income, will he be able to deduct his housing expenses somewhere else on the Form 1040?

Answer:

This questions brings up a couple of issues. First, most ministers are properly classified as employees who receive Form W-2, not as independent contractors who receive Form 1099-MISC. On Form W-2, Box 1 for taxable compensation is reduced reflecting the church's designation of a portion of his pay as non-taxable. Then in Box 14, it typically reports as a memorandum item his additional non-taxable, housing allowance compensation. In the situation addressed in the question, this Form W-2 reporting may or may not adequately address the other uses the church must make of the Form 1099-MISC.

Alternatively, the minister will need to report the full Form 1099-MISC income on Schedule C where it will be fully taxable. The minister could then claim as a deduction on Line 21 of his Form 1040 as Other Income a negative amount for his allowable housing allowance. He should probably attach an explanation of the negative amount and be ready to answer correspondence from the IRS regarding the deduction.

Of course, the full amount of compensation (including the non-taxable housing allowance) is subject to self-employment tax on Schedule SE unless the minister has successfully applied for exempt status using Form 4361.

Two Residences for Housing Allowance Purposes?

Questions:

A minister temporarily commutes 100 miles from his principal residence to serve in a Christian ministry, also renting an apartment near the ministry while away from home. Can he claim a housing allowance on this second dwelling as well as his principal residence?

And what about the commute from home to the ministry--is it deductible? Can the ministry reimburse him on a tax-free basis?

Answers:

A housing allowance is available for only one principal residence. Plus, commuting from a minister's home to his place of business is non-deductible. Hence, reimbursements by a church for non-deductible expenses, while certainly appreciated, will be taxable income.

An exception may be important to consider. It relates to the Internal Revenue Code definition of Tax Home. Travel and lodging expenses while away from one's Tax Home for business purposes may be deductible (and reimbursements non-taxable). According to IRS Publication 463, "if you do not have a regular or a main place of business because of the nature of your work, then your tax home may be the place where you regularly live" (IRS Pub. 463, 2/4/2009, p. 3). It's important to carefully consider the "factors used to determine tax home" that are spelled out by the IRS. Some ministers who serve multiple ministries from one central location (their homes) may deduct mileage to travel to those ministries and lodging & meals while out-of-town, overnight to conduct their ministries. However, "itinerant" status ministers do not qualify for these deductions.

Ministers employed by a single ministry even if it requires significant travel and overnight lodging do not qualify for these deductions.

September 09, 2009

Minister Performing Services as an Independent "Business" Activity

Question:

Can a private pastoral counseling practice - including pastoral counseling, church consultation, and education - qualify for the housing tax deduction? The individual seeking ministerial status is not paid by his church; however, his ministry is affirmed as an extension of a church's ministry. Essentially, he operates a sole proprietorship earning income that supports his ministry at a church.

Answer:

IRS Publication 517 addresses this situation in its definition of a minister:

"Most services you perform as a minister, priest, rabbi, etc., are qualified services. These services include: performing sacerdotal functions, conducting religious worship, and
controlling, conducting, and maintaining religious organizations (including the religious boards, societies, and other integral agencies of such organizations) that are under the authority of a religious body that is a church or denomination."

Publication 517 also addresses services for nonreligious organizations:

"Your services for a nonreligious organization are qualified services if the services are assigned or designated by your church. Assigned or designated services qualify even if they do not involve performing sacerdotal functions or conducting religious worship. If your services are not assigned or designated by your church, they are qualified services only if they involve performing sacerdotal functions or conducting religious worship."

It seems that the individual described in the question may not qualify for ministerial status. If he and a Board of Directors establishes a qualified IRC 501(c)(3) organization "under the authority of a religious body that is a church or denomination" (see above), then that organization can designate a housing allowance. Alternatively, the church may recognize his contribution to its ministry and hire him as a counseling minister employed by the church. Of course, he loses the autonomy that he now enjoys as a sole proprietor.

Benevolent Fund Review

Question:

I have currently been made aware of a family in our church that has experienced some serious medical issues. One of our members would like to pay for these expenses. The only stipulation that I can find in the Internal Revenue Code is that the money cannot be given with a particular designation. Can the church receive these funds, give a tax-deductible receipt or acknowledgement to the donor, and disburse the funds to pay these medical expenses?

Answer:

Churches maintain ongoing Benevolent Funds to prepare to meet these type of needs. All members are generally encouraged to give monies to the fund to allow the church (through an authorization process observed by church officers) to respond.

The caution that I offer is that the church must avoid becoming a conduit for donors to convert their noncharitable obligations into tax deductible gifts. For example, if one family member "donates" a substantial portion of the benevolent monies given to another immediate family member (even stipulating that the funds may only be used to do so), then the church may find itself being "used" to convert his or her obligation to pay for family medical bills into a chartible contribution.

I recommend that churches communicate that gifts to their benevolent funds are disbursed solely at the discretion of the church. This does not mean that members cannot communicate needs of others that they have discovered and that they are willing to help meet.