YOU CAN TAX-AUDIT SAFE
By: Daniel D. Busby
Each year an estimated six thousand–or more– pastors are audited by the IRS.
Will you be next?
Worth considering: If you file your income-tax return with certain safe harbors in mind, you can freely hand over any records to an IRS auditor without worrying about the result.
What are a pastor’s safe harbors? Here are some clergy tax-problem areas and their corresponding sanctuaries from a sense of back-tax paranoia.
Reporting as Self-Employed
Many ministers continue to report their primary ministerial compensation on IRS Form 1040, Schedule C, as self-employed individuals.
Problem: The IRS, applying a common law employee test, classifies most local-church ministers as employees. Inappropriately filing as self-employed for income-tax purposes puts you in a high-risk category for reclassification as an employee by the IRS. Result: Audited pastors can be liable for underpaid back taxes and penalties.
Note: Fees and honoraria received for services provided directly to church members, such as baptisms, marriages, and funerals, should be treated as self-employment income for income-tax
purposes. Also: All qualified ministers must file as self-employed for social security-tax purposes. But few ministers qualify for independent-contractor status on their salary for income-tax
Added problem: If you choose to report your church salary on Schedule C, you almost double your IRS audit exposure. The latest statistics show:
Of those with income between $25,000 and $100,000 who file a Schedule C, 1.92 percent were audited.
Of those with the same income who didn’t file a Schedule C, fewer than 1.02 percent were audited.
Safe harbor: The vast majority of pastors generally should file as employees for income tax purposes and receive a Form W-2 from the church.
Exception: Use Schedule C for your church salary only if you have an air-tight case for independent-contractor status.
Mixing Salary and Reimbursements
Ideally, the church should reimburse the minister for 100 percent of professional expenses. The next-best option is to reimburse the minister for validated expenses up to reasonable limits.
Trap: some churches, wanting to be flexible, begin to blur the distinction between salary and expense reimbursements. Here’s an example of how the problem develops:
The church decides it can afford a certain amount for the minister’s salary and professional expenses–say, $36,000 annually.
The minister receives $3,000 per month, tentatively allocated as $2,500 salary and $500 professional expenses.
At some point, often the end of the year, the minister realizes the professional expenses exceed the $500-a-month allocation.
The church then adjusts the allocation so that, say, $2,400 a month is salary and $600 reimburses expenses. Note: The allowance reduces the salary to the amount remaining after expenses are
Problem: The IRS frowns on this practice, terming it recharacterization of income. Result: The entire salary and expense reimbursement package probably will be considered gross
compensation. That means the pastor will have to pay income tax on the reimbursement portion of the remuneration (unless the expenses are deducted on Schedules A or C), as well as on the true salary. Added problem: All the expenses become liable for an IRS audit.
Safe harbor: Use a stated-salary approach. Set your gross salary at the beginning of the year and don’t try to adjust it during the year based on your level of business and professional expenses
reimbursed by the church. Important: This means a change of practice for many pastors and churches.
Explanation: The IRS expects a minister to receive an established salary not subject to frequent or retroactive adjustments. The pattern should be similar to the salary administration for most
nonministerial employees. Note: It is acceptable to make midyear salary adjustments not based on the level of professional expenses incurred.
Nonaccountable Expense Allowances
Professional-expense allowances that are tacked to salary and are received regardless of actual expenses are considered merely another form of gross income by the IRS. Result: Such allowances
(called nonaccountable plans) must be reported as income on your tax return, and you must pay taxes on them.
Better: An accountable reimbursement plan works this way:
You keep records of such business and professional expenses as travel, entertainment, conferences, books, and materials.
For church-related entertainment expenses, you record the business purpose, business relationship, cost, time, and place.
You submit your documented expenses monthly to the church for reimbursement.
You return promptly any excess reimbursements (such as unused portions of a travel advance) to the church.
Benefit: An accountable expense reimbursement plan makes your business and professional expenses audit-proof. You do not report these reimbursed expenses on your tax return. Result: An IRS
auditor cannot ask to examine your expense documentation.
Safe harbor: Ask your church to adopt an accountable expense reimbursement plan and follow it religiously. Implication: Don’t try to deduct your business and professional expenses on your tax
return and risk losing many of the deduction benefits.
Caution: Office-in-the-home deductions for ministers are tricky and practically invite an audit. Since few ministers qualify for the deduction, there is too little gain for too much risk.
Unsubstantiated Auto Expenses
Ministers traditionally have been paid three ways for driving their cars for ministry purposes:
Mileage. The simplest way has been to pay the flat mileage rate allowed by the IRS (27.5 cents per mile in 1991 and 28 cents for 1992). This method necessitates keeping a log of miles driven for
Actual expenses. This choice, usually more generous, is to reimburse pastors for actual costs of owning and operating the vehicle. Problem: This requires detailed records of every expense,
which few ministers enjoy keeping and reporting to the church. Added problem: The hassle of figuring yearly depreciation because of “luxury car” limitations (a car is “luxurious” if it costs over
$13,400) and the possibility of a lengthened depreciation period.
Auto allowance. The least effective method is to provide an auto allowance with no documentation required. Trap: Such a nonaccountable reimbursement plan is considered additional taxable
compensation by the IRS.
Safe harbor: Set up an accountable reimbursement plan using one of two methods:
Mileage: Keep an accurate log of miles driven, and use an auto-expense reimbursement of 28 cents per mile (for 1992) for ministry-related miles.
Note: Although the reimbursement may be a little less than what you could receive from the actual cost method, a few misplaced receipts could easily lower actual-cost reimbursements to a figure
close to the mileage method.
Actual expense: If you love to keep records, use the actual-expense method, but remember to compile and retain accurate and complete records for verification.
Risky Housing Allowances
Every minister should have a properly designated housing allowance since even most ministers living in church-provided housing have some allowable housing expenses.
Problems: Sometimes housing allowances aren’t designated according to IRS regulations. The IRS disallows such practices as:
Pastors setting their own housing allowance without an official action by the church or board.
Establishing a housing-allowance figure retroactively after compensation is paid. Tip: Have the church designate the housing allowance in a standing resolution. You will be protected if you
forget to have a new resolution passed by the church board before a new year begins.
Failing to report excess housing allowance as taxable income. Explanation: If your actual housing expenses are less than the designated allowance, the difference is taxable.
Risk: The IRS can disallow the entire housing allowance, causing the amount to be taxable income. This can result in hundreds to thousands of dollars of added taxes.
Safe harbor: Have the church: (1) in an official resolution, (2) make a written designation of the housing allowance, (3) before compensation is paid.
In addition: The housing allowance can be no greater than the least of the following factors:
The fair rental value of the home in furnished condition, plus utilities.
The amount spent from current ministerial income to provide the home.
The amount properly designated by the church.
Reasonable compensation. Note: The vast majority of pastors won’t come close to problems with the nebulous definition of “reasonable,” since it generally denotes a much larger figure than
Fringe Benefit Fuzziness
All fringe benefits are not necessarily tax-free. Tax law does, however, provide a tax-free safe harbor for benefits such as:
Health insurance premiums paid by the church directly to the insurance carrier.
Group term life insurance up to $50,000 provided by the church.
Payments by the church to a denominational pension plan.
Tax-sheltered annuities within certain annual limits.
Problem: Some so-called fringe benefits are taxable income, such as:
Gifts from individuals that have been given through the church. Note: Money you receive directly from an individual is usually a personal gift and may be excluded from income, although the giver
cannot deduct the gift as a charitable donation.
Group term life insurance in excess of $50,000.
An allowance paid to help cover self-employment tax expenses.
Safe harbor: When figuring your taxable income, include the value of all fringe benefits not specifically excluded by tax law.
That Safe Feeling
Smile at an IRS audit? Well, maybe not. But if you use safe harbors, you may never be audited. And if you are, you’ll pass the scrutiny with freedom from anxiety.
(The above material appeared in the Mar./Apr. 1992 issue of Your Church Magazine.)
Christian Information Network