I have had a lot of experience over the years with local ministers from some of the largest churches down to new church “plants” and home churches. Taxation for ministers can become very complicated and costly errors can easily be made. It is very important you understand the rules – especially if you are minister that is not exempt from self-employment tax (FICA and Medicare).
Given that all requirements are met, most ministers have the option to exempt themselves from self-employment tax (SE tax). Usually, the “career” ministers that plan to work as a minister until they retire select this option. However, there are a lot of worship ministers and other types of assistant ministers that may have worked many years in other professions before becoming an ordained minister, or they are bi-vocational and work part-time as a minister. This group often will not exempt themselves from self-employment tax, which actually creates some extra tax complexities. If you are in this group, it is crucial you read this post and become very familiar with IRS Publication 517. However, let me first issue a word of caution to those of you who are exempt from SE tax.
Ministers exempt from SE tax
There are good arguments for and against exempting yourself, and hopefully you talked to a CPA or accountant before making your decision. What I would caution you with is to make sure you are religiously saving the 7.65% you would be paying and investing it for retirement. Make sure you are not being like the politicians and borrowing from this fund no matter what the circumstance – you do not want to get to retirement with a suitcase full or IOUs. Also, buy adequate term life insurance to protect your wife and children since they will be turned away from the social security office in the unfortunate event that you die. Finally, you cannot depend on church pensions in this economy. Yes, in the past churches and conferences were very generous in taking care of retired pastors; however, many churches and organizations have been forced to make cuts and are slowly changing their retirement benefits to more closely resemble similar plans found in private industry.
Now to the actual tax complications. For those of you who receive a housing allowance and have employee expenses on a 2106 or expenses on a Schedule C that offset wedding, speaking, or other income, it is important that you calculate the non-deductible portion of your expenses allocable to the tax-free housing allowance. In plain English, a portion of your expenses are actually non-deductible (see page 9 of Publication 517) because you are receiving tax-free income. To calculate the non-deductible portion, multiply your expenses by total housing allowance divided by all ministry income. For example, if you have a $24k housing allowance and $75k in total earnings, 35% of your expenses would be non-deductible.
For some of you this is a moot point as you do not pay income tax or would get no benefit from the deductions, but it is important to note since every minister’s situation is different.
Ministers not exempt from SE tax
I have a heart for this group – especially the worship ministers – as I have been involved with leading worship for over 15 years and I know that they do a lot of work in their jobs and it is a bit unfair that they get stuck with further tax complications.
First, since they are not exempt from SE tax, the housing allowance amount needs to be put Schedule SE and made subject SE tax. The housing allowance is tax-free for income tax purposes, but not for SE tax as it is an entirely separate tax. This can have a huge impact on your tax liability, so make sure your employer is taking out ample Federal withholding.
As with ministers exempt from SE tax, you will need to calculate the non-deductible portion of your expenses before completing your 2106 or Schedule C. The only difference is that the non-deductible expenses are not a total loss in that they provide a small benefit for the non-exempt ministers. The non-deductible expenses are then used to reduce the amount of housing allowance subject to SE tax. For example, let’s say you had $18k in housing allowance subject to SE tax and $2k in non-deductible expenses. The $2k in expenses otherwise lost would lower SE taxable income to $16k. Even though the taxpayer would probably have better benefit claiming the expenses, at least some benefit can be taken for the non-deductible expenses.
This treatment is missed even by seasoned CPAs, so make sure you look at your return even if you use a CPA and review the comprehensive examples in the back of Pub 517. The IRS publication also gives examples of the statements needed in the tax return and wording to be used.
I hope that helps! If you have additional questions, feel free to comment or email me. In part 2, I will discuss 1099s and go over the housing allowance in more detail.