AVOIDING AN AUDIT
BY RICHARD R. HAMMAR
How likely are you to be audited? Ministers who report their income taxes as employees, earn less than $100,000 per year, do not have excessive itemized deductions, and do not claim any “audit triggers,” have an audit risk of about 1 percent. This is close to the overall audit risk for all taxpayers. There are about 500,000 ministers in the United States, meaning that 5,000 of them could be audited each year.
Of course, some regions have higher audit risks. The audit rate is highest in the IRS Western region (Alaska, California, Hawaii, Idaho, Nevada, Oregon, and Washington).
Since moving isn’t much of an option, here are eight tips for ministers to reduce the risk of being audited.
1. Report income taxes as an employee. The legal landscape has changed since a 1994 tax court’s ruling that a United Methodist minister in North Carolina could not report his church compensation as a self-employed professional for federal income tax purposes. The court concluded that, for income tax purposes, the minister was an employee of the church.
The evidence is mounting-taxpayers who report their income taxes as self-employed workers face a far higher audit risk than do those who file as church employees. According to recent IRS data, the chances of a self-employed taxpayer being audited are as much as 400 percent greater than for an employee with the same income. What’s the lesson? If you report your income taxes as a self-employed person, you’re asking for IRS scrutiny.
Why are self-employed taxpayers a target? Government statistics demonstrate that the “voluntary tax compliance rate” of self-employed persons is a dismal 13 percent compared with a 99 percent rate for employees covered by mandatory tax withholding.
2. Pay self-employment (social security) tax on all your salary– including housing allowance. Many ministers overlook the fact that the housing allowance is an exclusion for income tax purposes only. It is not available in computing your self-employment (social security) tax. Claiming the housing allowance in computing self-employment taxes will lead to a substantial understatement of tax. If the understatement exceeds the greater of (1) 10 percent of the actual income taxes that should have been paid, or (2) $5,000, then you will owe a special “substantial understatement” penalty: 20 percent of the underpayment. Further, the period of time during which the IRS can audit you for this item may be increased from three to six years.
3. Follow the Deason Rule. According to the Deason Rule, named after a 1964 tax-court ruling, ministers must reduce their business expense deductions by the percentage of their total income that consists of a tax exempt housing allowance.
Let’s say a minister has a total compensation of $40,000, of which $10,000 is a housing allowance. Any business-expense deduction, then, must be reduced by 25 percent (since $10,000 is 25 percent of $40,000). If this pastor had $4,000 of business expenses, his or her business expense reduction would be reduced from $4,000 to $3,000.
While the IRS did not enforce this rule many years, it is now. The edition of IRS Publication 517 contains helpful guidance on reducing your business expenses under this rule.
4. Get the church to reimburse your expenses. To avoid the Deason Rule and reduce your risk of an audit, your church can reimburse your business expenses with an accountable arrangement. Properly substantiated business expenses reported to the church rather than to the IRS lowers the chance of an audit. Reimbursement payments are not reported as taxable income. In fact, because they were fully reimbursed, the minister’s business expenses are not reported anywhere on Form 1040.
Since the IRS focuses on business expense deductions, you will reduce your audit risk by eliminating them from your tax return. (Caution: Personal expenses cannot be reimbursed under such an arrangement. Nor can the cost of commuting between your home and the church.)
5. Watch your itemized deductions. Some taxpayers have a much higher risk of being audited because their itemized deductions exceed ranges established by the IRS. While the IRS does not publish its audit criteria, it does publish the aver age itemized deductions claimed by taxpayers based on the amount of their income. This information is helpful in comparing the size of your deductions with the average amounts claimed.
6. Know the “audit triggers.” Several deductions increase your audit risk: home office expenses, entertainment expenses, and education expenses. If you claim a deduction for any o these, be sure you satisfy all of the leg requirements. The rest of your tax return may be examined too, so be sure you are not taking unreasonable positions with respect to any other item.
IRS data reveal what most would expect your audit risk increases with your income. The more income you earn, the greater your audit risk. High income ministers should be more cautious in preparing their tax returns.
7. Keep adequate receipts. If you claim a deduction for unreimbursed business expenses or expenses reimbursed under a nonaccountable arrangement, you must have adequate records to substantiate most deductions. In general this means that you have documentary evidence to prove the amount, date, place, and business purpose of each expense. Receipts are required for expenses of $75 or more.
Be sure you have receipts to substantiate your housing expenses. The amount of your salary designated by your church as a housing allowance is not reported as taxable income (for income tax reporting purposes)– but only if the allowance is used for housing expenses. This means that if you are audited, you may be asked to prove that you had housing expenses equal to or exceeding your housing allowance.
If your housing expenses do not equal or exceed your housing allowance, this can lead to substantial additional taxes with interest and possibly penalties. Solution: Report only the amount actually spent on housing expenses. The remainder of any designated housing allowance should be reported as taxable income.
8. Report all income. Many ministers fail to report all items of income. Common examples of overlooked items include Christmas and other special occasion “gifts” paid to the minister by the church, personal use of a church-owned vehicle, and no interest or low-interest loans. Failure to report these items can lead to significant additional taxes in the event of an audit.
Richard R Hammar, J. D., LL.M., CPA, attorney-at-law, serves on the advisory board of YOUR CHURCH and is editor of Church Law & Tax Report. Reprinted by permission from LEADERSHIP.
WHY CASHLESS DONATIONS ARE TAX SMART
Donors considering a noncash gift to a church or a charity can use several strategies to make their gift go further and also save taxes. Here are answers to some common questions.
What’s a “noncash gift”? A nontech gift can include shares of stock or mutual funds, bonds, real estate, a stamp collection, or other financial or tangible assets-anything of value that can be converted into cash. One person I know donated his collection of antique firearms to his church.
Should a person sell the asset to convert it to a cash gift? No. While it may be simpler for a church to just receive a check, in most cases this would mean a smaller donation. Encourage people to talk to your treasurer or a tax attorney before they make any moves.
Why not sell the asset first? Let’s say someone has stock originally worth $2,000 but now worth $5,000. If the shares are sold before being donated, here’s what happens:
Sale Proceeds $5,000
Less tax* $840
Net gift to church $4,160
Donor owes capital gains taxes (28% on $3,000 profit).
What’s the better way to give a noncash gift? By simply switching the order of two events–the donation and the sale of the asset–you can simultaneously make the tax bill disappear and make the donation grow larger. When the asset is given first, allowing the church to sell it (instead of it being sold first and the money being given to the church), here’s what happens for the donor:
Value of gift $5,000
Tax deduction for giver $5,000
(instead of $4,160)
Savings on capital gains $840
Here’s what happens for the church:
Church’s sale proceeds $5,000
No tax owed exempt) $0
Net gift to church $5,000
(instead of $4,160)
Eric Henning is co-editor of The Cornerstone Investment Letter, which teaches in plain English biblical principles of saving and investing. For a free sample issue, call 800/727-1007 and mention YOUR CHURCH magazine. magazine. Excerpt from The Cornerstone Investment Letter reprinted by permission.
THE ABOVE MATERIAL WAS PUBLISHED BY YOUR CHURCH, MARCH/APRIL, 1996, PAGES 22,23. THIS MATERIAL IS COPYRIGHTED AND MAY BE USED FOR STUDY & RESEARCH PURPOSES ONLY.