SURVIVING AN IRS AUDIT: PART 4
J. M. MONTGOMERY
One of, if not the most important tax benefits available to a minister has been the value of a housing allowance. The Internal Revenue Code (Section 107) states that the fair rental value of a parsonage is not subject to federal income tax and that a housing allowance is not taxed to the extent it is used to provide a home.
In as much as the rental allowance is not considered taxable income and that the interest and taxes paid on the home have been deductible, it is easy to see just how important this tax benefit is. Seldom does Uncle Sam, through the good graces of his IRS, give anyone a double tax break, but this has been the case in housing allowances. You will notice my use of the past tense when referring to tax breaks, and as you might suspect, I am leading up to bad news regarding the “good deal” pastors have been accustomed to. In early 1983 the IRS issued a Revenue Ruling, 83-3. That ruling now prohibits clergy from deducting interest and real estate taxes on Schedule A when the clergyman has received a housing allowance to pay these costs. Revenue Ruling 83-3 became effective July 1, 1983. But for ministers receiving housing allowances and owning a house prior to January 3, 1983 the ruling will not be applied until January 1, 1985 or the date on which the minister no Longer occupies that home. Ministers who purchased homes after January 2, 1983 are immediately affected by this new ruling.
The question of who qualifies for housing allowance and the right and wrong ways to handle housing allowances are important issues faced by many in the ministry.
Previously, we have seen clergymen as basically pastors of a flock. For the sake of housing allowances, we will broaden our scope to include ordained clergy (in some cases, licensed or commissioned) in all phases of the Lord’s work. There are times when what seems logical and right will be looked upon as illogical by the IRS. For example, we may have a clergyman who is
employed as a teacher or administrator by a school, college, or university. If the educational institution is under the authority of a religious body constituting a church or church denomination, the clergyman can qualify for the rental allowance exclusion. Under these stipulations he is regarded to be performing services in the exercise of his ministry. However, such is not the case if the ordained minister’s specific duties do not involve ecclesiastical functions and/or the educational institution on whose faculty he is serving is not under the authority of a religious body. Then he cannot qualify and cannot exclude from his income either a housing allowance or the value of the home furnished to him.
Those churches that designate religious workers as minister of music or minister of education must be aware that without the ordination and authorization to perform all of the ecclesiastical duties of a duly ordained minister of the gospel, those persons may not exclude from income a rental allowance or the value of a home furnished them.
Another special case that concerns rental allowances or parsonages furnished to the pastor occurs when Bible college or seminary students are used as part-time, interim pastors or assistant pastors. These students, unless they are duly ordained, may not exclude rental allowances; in the case of a furnished parsonage, they must show fair rental value as income. As we have stated, the rules do not have to make sense; they just have to be kept.
How Much Is Allowed?
There also seems to be confusion on the part of many pastors and church administrators regarding the amount for housing or parsonage allowances. The question seems to be: “What may I include in the allowance?” The IRS has not put a ceiling on the amount that can be designated; however, the IRS takes the position that the allowance should not be higher than the fair rental
value of the home, including the cost of providing furnishings, the cost of additions such as a garage, and utilities. Note that the IRS uses the words “fair rental value.”
In some parts of the country, home prices have skyrocketed as a result of inflation and housing shortages. Some pastors, who own their own homes and have owned them for some time, have been advised to refinance their homes to the maximum loan as a means of reducing their taxable income. This, of course, increases the amount of the mortgage payment. I should warn pastors that the
total cost of their new mortgage repayment may exceed the fair rental value, particularly when taxes and insurance are added. The parsonage or housing allowance was not, nor is it now intended to be a gimmick to be used for profit. It was intended to help the pastor by relieving him of a tax burden, not to help him avoid taxes.
What Can Be Excluded?
A pastor may exclude from his gross income such housing expenses as:
1. Rent or mortgage payments, or a down payment on a new home
2. Taxes and interest
3. Insurance on his home and its contents
4. Repairs and upkeep on his home
5. Cost of furniture and appliances, and their repair
6. Utilities, including trash pickup and cable TV
You can see that the allowance is without a doubt one of the largest tax breaks pastors will ever be given. I pray that it won’t be abused.
IRS regulations state that a duly ordained minister of the gospel may exclude from his gross income the rental value of a home (including utilities) furnished to him as part of his compensation or the rental allowance paid to him as part of his compensation to the extent that such allowance is used by him to rent or otherwise provide a home. However, he must use the allowance in the year it was received to provide a home or pay utilities for a home furnished to him. Here is the part I find most often neglected. The clergyman receives the benefit of exemption only if the church or organization which employs him officially designates the payment as a rental allowance before the payment is made. A resolution by an executive committee of a national church agency is not sufficient to designate a rental allowance for ministers who are paid by a local congregation. The local congregation must officially designate that part of his compensation as rental allowance; if no part is officially designated as such, then the entire salary is includable in the clergyman’s income. ”
Contract of Employment
In my opinion, every clergyman should have a contract of employment, but not because of potential disagreements between the board and the pastor.
The contract could help the pastor avoid potential problems if and when he is audited by the IRS. As a minister he is considered to be self-employed and thus must file a Schedule C (Profit or [Loss] from Business or Profession) of Form 1040 (see note at end of chapter). Because he is considered to be a professional, his professional expenses are deductible when they are “ordinary
and necessary” to the successful completion of his profession. In an audit he should be prepared to show that each area of expense is ordinary in the work of the ministry and necessary to its fulfillment.
One of the reasons I am in favor of contracts of employment for pastors is that most auditors are not knowledgeable regarding the ministry and what it involves. Their opinion of what is “ordinary and necessary” most likely will not agree with that of a pastor. The auditor will have to be convinced that the expense as entered on the Schedule C is a common occurrence in the pastor’s job and that his ministry would not have been as complete or successful without the expense. Remember, the auditor is used to seeing a Schedule C completed by a businessman or professional in a profit-making enterprise.
The pastor will have to show him that success in the ministry is not predicated on financial profit, but on the fulfilling of the call that God has put upon the clergyman’s life. If the pastor has an employment agreement, it will spell out his call. It may say, for example: “The pastor is to preach the gospel, administer the ordinances of the church, instruct the flock, strengthen the weak, give comfort to the hurting, and care for the needy.”
The contract or employment agreement can and should spell out the housing allowance arrangements. If the pastor is questioned regarding these matters, the agreement, in most cases, will convince the auditors that the Schedule C expenses are legitimate and will prove his official designation regarding his housing allowance.
This, in my opinion, is the best and most ethical way to handle the housing allowance for all concerned, including the Treasury Department. In the event the Local church does not wish to make an employment contract, the next best method would be a resolution which is entered in the minutes.
You will recall that a clergyman employed as a teacher or administrator of a school, which is under the authority of a church, can qualify for the housing allowance exclusion if he is an ordained minister and if he performs his functions as a clergyman. Remember, though, that a clergyman who performs the same function but is not under church affiliation may not qualify for the
exclusion. This being the case, what about evangelists and other clergymen who are in the ministry but not affiliated with a church? I am sorry to say that a 1978 Revenue Ruling put many clergymen into a position of doubtful qualification for housing allowances. The new ruling seems to indicate that, unless the clergyman has church affiliation or is under the control of the
church, he most likely will not qualify for the housing allowance exclusion (Revenue Ruling 78-172, IRB, 1978-19.9).
Another area of confusion exists that is related to the pastor and Social Security. A large part of the confusion stems from the change in the Social Security Act as it relates to the clergy after 1967. For the sake of our discussion in this chapter, we will deal with post-1967 rulings and try to avoid any more confusion by not discussing any of the pre-1968 rules.
The first area of confusion for many people has been the dual name of Social Security coverage. It is important to know that self-employment tax, Social Security coverage, and FICA all mean the same thing. The term Social Security coverage is normally used when a person is an employee. For our purposes, we will use the term self-employment tax. The reason for our use of this term can be found in the language of IRS Publication 517.
For social security purposes, you [a minister] compute your earnings from services as a member of the clergy as if you were self-employed, even though you may be performing those services as an employee.
I have talked with pastors who have assured me that their churches are paying their self-employment tax. This may be true, but look at what the IRS says about that. Again I quote from Publication 517.
If a church pays any amount toward your [a minister’s] obligation for your income tax or self-employment tax other than from your salary, this is additional income to you and must be included in your gross income and self-employment income.
It is also important to note that a minister’s pay for service in the exercise of his ministry is not subject to income tax withholding. However, a minister may be able to enter into a voluntary withholding agreement with his employer to cover any income tax he may have due.
A church’s voluntary withholding of income taxes is covered by Internal Revenue Code Section 3402(p)(2). This section states that, for the purpose of Internal Revenue Code Chapter 24, “renumeration or other payments with respect to which such agreement is made shall be treated as if they were wages paid by an employer to an employee . . .”
Tax Forms for the Clergyman
Over the Last few years a great deal of confusion has come about as a result of a lack of consistency regarding whether or not a pastor is self-employed. The use of Schedule C is open to various opinions. Some believe that income should be reported on a W-2 form and the pastor should be considered a common law employee. Others think that income should be reported on a 1099
form and the pastor should be regarded as a self-employed individual.
In l98O the IRS used Revenue Ruling 80-llO in an effort to clarify the tax reporting of ministers. This ruling did not attempt to address the question of the employment status of ministers. Rather, it presumed that the minister is an employee-in my opinion, a presumption that was neither called for nor accurate. Suffice it to say, if you as a pastor have been considered self-employed (i.e., use tax forms 1040-ES, Schedule C, and Schedule SE) and your income is reported on a 1099, I would ask you to consider carefully the merits of this before you request a change to employee status. If, in the past, you have been considered an employee by your organization, you might want to read any one of a number of books, particularly Shepherd of Hireling? In this work, the authors lend sound support for the self-employed status of ministers.
One of the strongest arguments for the self-employed status of the minister is the precedent set over the past many years. Courts of law and legislative bodies pay close attention to precedent in the determination of a particular point of law or interpretation of law.
It must be pointed out that if there is a whole-sale switch by most ministers to the methodology suggested in Revenue Ruling 80-110,a new precedent could establish itself which could have the effect of solidifying an otherwise questionable procedure. Denominational leaders, clergy tax authors, and others to whom ministers listen may suggest compliance with this Revenue Ruling and actually enhance its status into a precedent. Thus may come to fulfillment that famous Pogo statement: “WE HAVE MET THE ENEMY AND HE IS US! “”
This is a good place to stress the forms required of an ordained minister in the exercise of his ministry. As an ordained minister, you are considered to be self-employed even though you work for a church or church organization. As a self-employed person, you are required to file income tax forms: 1040-ES (Declaration of Estimated Tax for Individuals), Schedule C (Profit [or Loss] from Business or Profession), and Schedule SE (Computation of Social Security Self-Employment Tax), in addition to your regular Form 1040.
It would be wise for pastors to visit the local IRS office and pick up Publication 505 (Tax Withholding and Estimated Tax). Many younger pastors may be surprised, par- ticularly those in smaller, nondenominational churches; few seem to be aware that a clergyman must file a declaration of estimated tax on Form 1040-ES. He must pay the estimated tax or at least the first installment
on or before April 15 of any year in which he expects to owe income tax and/or self-employment tax of $100 or more. If he is abroad on April 15, the filing date is automatically extended to June 15.
To Be Exempt from Social Security
Recently, a young pastor visited my office for some advice regarding his personal finances. In the course of our conversation, he informed me that he was not going to pay any Social Security. He had been advised that he could send in a form and not have to pay it. He also was told that all that he had paid to Social Security in the past could be “frozen” and thus be available to him at a later date.
Let’s look at the facts, as viewed by the IRS in Publication 517.
The earnings that you receive as a member of the clergy are automatically covered and are subject to self-employment tax unless you are a member of a religious order and have taken a vow of poverty, or unless you request and receive from the Internal Revenue Service an exemption on religious grounds that you are opposed by reason of conscience or religious principals, to accepting social security benefits… based on your services as a member of the clergy. Members. . . who file Form 4361 claiming exemption from social security coverage solely for economic considerations have not made a valid election and must pay self employment tax.
The opposition need not be to the acceptance of all public insurance, only to the acceptance of payments which are based on services performed as a minister. Thus, a clergyman may still be eligible for exemption, even though he isn’t opposed to Social Security benefits with respect to services he performed outside the exercise of his ministry. We can see that the young man could have
filed Form 4361 and excluded himself from Social Security on his earnings as a minister, yet could pay Social Security on earnings from any other job he might have at any time.
I am sure there are circumstances where the exemption would be appropriate, but in this case, the young man just did not want to pay the self-employment tax because he was convinced the system would not be in operation when he was old enough to collect. As we have seen, the exemption is not valid if the objection is for any reason other than “conscience or religious principles. ”
There is another reason for reading Form 4361 closely. In Section J of the instructions, it states: “You may not revoke the exemption once it is received.” Also, you need to be aware that Form 4361 cannot be filed later than two years after you have received earnings of $400 or more per year as a clergyman.
Benefits for Survivors
Many look at Social Security simply as retirement benefits, when in reality the best area of protection is the benefit paid to survivors (i.e., the pastor’s wife and children in the event of his death). For example, let us take a typical pastor, forty-five years old, who has two children. Let’s assume his children are ages twelve and fourteen, and his wife is age forty. We will estimate a conservative 3 percent inflation rate per year for the next twenty years.
In the event the pastor dies and is sufficiently covered by Social Security, what can his family expect in the way of benefits? His family should receive a lump sum payment at his death of $255, and Mrs. Pastor can expect an approximate average of $793 a month until the oldest child is eighteen years of age. Then, while the youngest child is still under eighteen, she could expect approximately $750 a month. The income to Mrs. Pastor would stop when both children reach the age of eighteen. However, if the children remain unmarried and attend an accredited school, each child could expect to receive approximately $300 a month from age eighteen to twenty-two. These dollars would go directly to them, not to Mrs. Pastor. After her youngest child reaches age eighteen, Mrs. Pastor is in what is called the “blackout period.”
This simply means that she will not be entitled to any Social Security benefit until she is age sixty; in this case, that would be fourteen years.
From age sixty on, she should receive an average of $1200 a month. Remember, we have been inflating the projected benefit at 3 percent, and Social Security benefits could be changed by law.
Check Your Account
From the above illustration, we can see that Social Security is not just a retirement plan but a very valuable protection to the pastor’s family in the event of his death. Since the protection available to your family is so important, it is wise to verify that the Department of Health and Human Services (Social Security Administration) is correct in its record keeping for your account. Their own form letter stresses:
Unless you report an error within 3 years, 3 months, and 15 days after the year in which the wages were paid or after the taxable year in which the self-employment income was derived, correction of our records may not be possible.
To check on your records and status, simply write: Social Security Administration, P. 0. Box 57, Baltimore, MD 21203. Indicate your Social Security number and your date of birth, along with your name (as it appears on your card) and address. Ask for a statement of earnings and the number of quarters of coverage you have now. It would be wise to do this every three years to avoid possible problems at your retirement, death, or disability.
Now, what about Social Security disability benefits? The first thing you should be aware of is that Social Security benefits are not guaranteed as they relate to disability or any other benefit. The benefit may be lost in several ways. Let us take the language directly from the booklet Your Social Security.
Under social security, you’re considered disabled if you have a severe physical or mental condition which: Prevents you from working, and Is expected to last (or has lasted) for at least 12 months, or Is expected to result in death. Your checks can start for the 6th full month of your disability. Once checks start, they’ll continue as long as you are disabled. If you are severely disabled, you could get benefits even though you manage to work a little.
If a pastor who has not elected exemption from Social Security becomes disabled and he is not able to work in any substantially gainful job, and if he meets the work credits criteria, he will receive disability income after six months of his disability. Of course, the amount of income will be reduced if the pastor receives workers’ compensation or if he is able to earn money.
Let me define work credits for disability benefits. If you become disabled before you are age twenty-four, you need credit for one and a half years of work in the three years before you become disabled. If you are between ages twenty-four and thirty-one, you must have credit for half the time between your twenty-first birthday and the date you become disabled. If you become disabled after age thirty-one, you need as much credit as you would need if you reached retirement age in the year you were disabled. Five years of your work must be in the ten-year period just before you become disabled.
If you become disabled by blindness, the work requirement is somewhat different. You still need as much credit, but you do not need to meet the recent work requirements. It might be wise, at this point, to become familiar with some of the terms used in measuring insurability.
If a person is insured at all, he or she is either “currently insured” or “fully insured” or both. It depends on the “quarters of coverage” credited.
Quarter of coverage. A calendar quarter in which at least $50 in wages is paid to a worker, or any and all quarters in a year for which at least $400 of self-employment income is received . . . .
Currently insured. A status of limited eligibility that provides family death benefits only; does not provide old-age or disability benefits. To qualify as currently insured a worker need have only 6 quarters of coverage in the 13-quarter period ending with the period in which he or she dies….
Fully insured. A status of complete eligibility that provides benefits in the event the worker dies . . . or reaches retirement age . . . or becomes disabled . . . To qualify as fully insured, a person must have: (1) One quarter of coverage . . . for each calendar year that has elapsed after 1950, or after . . . he or she attains age 21, . . . up to the calendar year in which he or she dies, reaches age 62 after 1974, or becomes disabled, or (2) 40 or more quarters of coverage.
To attempt to outline the amounts you or your family might receive at a given time would take pages.
It would be wise for every pastor, regardless of his age, to visit a Social Security office. He could pick up some of the free booklets regarding benefit payments, not only for his own information but for others in his congregation.
Because the pastor is in a different position from other employees within his church, as it relates to employee status and Social Security, he at times doesn’t keep up with changes in various rules and regulations that pertain to churches. We have discussed some of these necessary rules and regulations without getting into the extremely technical aspects which are best left to men called into the ministry of administration. It is, however, important that the pastor be at least aware of new rules or changes in old rules.
There have been major changes recently in Social Security as it relates to churches. All churches are now required to pay Social Security taxes on the wages paid to all employees. All means exactly what it says-all, both full-and part-time employees. There are a number of forms and steps that every church must now pay close attention to. For those churches already paying the tax nothing changes; but for those churches who opted out until now it would be wise to spend time and effort to discuss this new situation with your local Social Security office or with a competent accountant. A congregation that fails to withhold these taxes faces heavy penalties. A word to the wise should be sufficient.