TAX



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|Unique tax rules apply to members of the clergy. |

Tax Planning for

Servants of God

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BY FRANCES E. McNAIR, EDWARD E. MILAM

AND DEBORAH SEIFERT

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|EXECUTIVE SUMMARY |

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|[pic]FOR CLERICS, GROSS INCOME does not include housing allowances paid as part of compensation to the extent the allowance |

|is used to rent or provide a home and does not exceed the fair rental value of the home plus the cost of utilities. However, |

|housing allowances are included in income for self-employment tax purposes. |

|[pic]TO QUALIFY FOR SPECIAL TAX TREATMENT, clergy must perform services in the exercise of their profession and be duly |

|ordained, commissioned or licensed. |

|[pic]THE DETERMINATION OF WHETHER A CLERIC is an employee or self-employed for federal income tax purposes primarily is based|

|on fact. |

|[pic]BUSINESS EXPENSES FOR TRAVEL to visit hospitals and nursing homes or to attend religious conferences and meetings are |

|allowable, but deductions for a home office rarely are allowed. |

|[pic]FEES PAID DIRECTLY TO THE CLERGY FOR BAPTISMS, bar mitzvahs, weddings and funerals are includable in income on schedule |

|C as self-employment income even if the cleric is considered an employee. |

|[pic]MINISTERS ARE SELF-EMPLOYED FOR SOCIAL SECURITY purposes even if they are treated as employees for federal income taxes.|

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|[pic]COMMON TYPES OF RETIREMENT PLANS AVAILABLE for employee clergy include IRAs, tax-sheltered annuities, qualified pension |

|plans, 401(k) plans, SEPs and Rabbi trusts. |

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|FRANCES E. McNAIR, CPA, PhD, is a professor of accounting at Mississippi State University. Her e-mail address is |

|fmcnair@cobilan.msstate.edu. EDWARD E. MILAM, CPA, PhD, is a professor of accounting at Mississippi State University in |

|Starkville. His e-mail address is emilam@cobilan.msstate.edu. DEBORAH SEIFERT, CPA, is a doctoral student at Washington State|

|University in Pullman. Her e-mail address is dseifert@mail.wsu.edu. |

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|[pic]ith today’s complex and ever-changing rules, annual tax planning is increasingly important for all taxpayers. However, |

|it’s especially important for members of the clergy because of three unique rules that apply to the income and Social |

|Security taxes they pay: the housing exemption allowance, the treatment of employee clergy as self-employed for Social |

|Security tax purposes and the exemption from withholding income tax from wages (but not from paying income tax on wages). |

|This article discusses tax-planning opportunities for clergy that CPAs in public practice need to know to best counsel this |

|special group of clients. |

|HOUSING EXEMPTION ALLOWANCE |

|A housing allowance is an important tax benefit for clergy because it can be excluded, within limits, from gross income for |

|federal tax purposes. It provides a way for many religions to supplement, tax-free, the usually low salaries they pay their |

|clergy. Continuing this tax-free status has strong bipartisan support, and in 2002 Congress passed legislation aimed at |

|settling the issue of what amount can be excluded from gross income. |

|IRC section 107, as amended by The Clergy Housing Allowance Clarification Act of 2002, states that “in the case of |

|ministers…, gross income does not include the rental allowance paid to him as part of compensation to the extent used by him |

|to rent or provide a home and to the extent such allowance does not exceed the fair rental value of the home, including |

|furnishings and appurtenances such as a garage, plus the cost of utilities.” The housing allowance must actually be used to |

|maintain or provide a furnished home and cannot be used for other purposes. |

|Housing Allowance for Clergy |

|Without the housing allowance they currently receive, America’s clergy face a devastating tax increase of $2.3 billion over |

|the next five years. |

|Source: Rep. Jim Ramstad (R, Minnesota), 148 Congressional Record H1300, April 16, 2002. |

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|In addition IRS Publication 17, Your Federal Income Tax, states that clerics who own their homes can exclude the lesser of |

|the following: |

|[pic]The amount actually used to provide a home. |

|[pic]The amount designated as a rental allowance. |

|[pic]The annual rental value of the home, including furnishings. |

|For clerics who own their own homes, actual expenses include mortgage interest payments, down payments, real property taxes, |

|insurance, utilities, furnishings, repairs and improvements. The limitation on the excludability of the clergy housing |

|allowance generally is effective for taxable years after December 31, 2001. |

|A cleric can receive a housing allowance for only one home, and the cleric’s church, temple or mosque must actually |

|designate, in advance, payments made for housing or utilities as housing allowances so there is no question these payments |

|are excludable from gross income. Ministers living in church-provided parsonages, for example, do not have to include the |

|fair rental value of their homes in their gross income and may exclude a designated allowance for utilities and upkeep to the|

|extent of actual expenses. According to revenue ruling 87-32, those who receive a housing allowance still are allowed to |

|deduct mortgage interest and property taxes on their federal tax returns as itemized deductions. |

|The Clergy Housing Allowance Clarification Act applies only to housing allowances and parsonage allowances for federal income|

|tax purposes. Housing and parsonage allowances have always been, and continue to be, included in income for self-employment |

|taxes. In addition, since the housing allowance is a part of total compensation, religious organizations must be careful to |

|avoid paying their clerics “unreasonable compensation,” which could jeopardize their tax-exempt status. While there is little|

|guidance on what is considered reasonable, CPAs should recommend that compensation packages above $125,000 be reviewed by the|

|board or documentation for support be provided. |

|DETERMINING FAIR RENTAL VALUE |

|Since clergy housing allowances are excludable only up to the maximum of fair rental value, the determination of what that |

|constitutes is of utmost importance. Figuring the fair rental value of a property would be simple if there were fixed |

|formulas, rules or methods. Usually, there is no single formula that applies when determining fair rental value. The fair |

|rental value usually is figured by examining the facts and circumstances of each instance, but in all cases should be based |

|on a furnished property plus utilities. The fair rental value of a furnished property as a whole should be used, not the fair|

|rental value of a property plus the fair rental value of the furniture. |

|The courts have allowed two methods for figuring fair rental value. Both assume that fair rental value is determined at arm’s|

|length, that is, objectively and between unrelated parties. The primary method has been comparable fair rental value based on|

|the testimony of an expert who compares the property in question with other similar properties. CPAs can regard reliable real|

|estate agents as experts, able to quote rental values based upon the location, size and condition of the dwelling. |

|The second valuation method allowed by the courts is the comparable sales method. This technique requires the determination |

|of two amounts: the fair market value of the subject property and the rate of return on investment that an unrelated lessor |

|of comparable property would require. The two numbers are multiplied to determine the fair rental value amount. The first |

|amount, fair market value, should be readily available from real estate sales records. The second figure, the required rate |

|of return, is more subjective. The Tax Court used 13% in the 1999 Hunt & Sons (66 TCM 853) case, but a higher rate of return |

|may be justified. A required rate of 15% probably would not be unreasonable. |

|WHO QUALIFIES? |

|It is common to think that all members of the clergy are eligible for special tax treatment, but this is not true. IRS |

|Publication 1828, Tax Guide for Churches, broadly defines ministers as “members of clergy of all religions and denominations |

|and includes priests, rabbis, imams and similar members of clergy.” But, according to Treasury regulations section |

|1.1402(c)-5, in order to qualify for special tax treatment as clergy, an individual must be a “minister” performing services |

|“in the exercise of his ministry” and a “duly ordained, commissioned or licensed minister of a church.” The services |

|performed by a minister in the exercise of the ministry include the “ministration of sacerdotal functions,” the “conduct of |

|religious worship” and the “control, conduct and maintenance of religious organizations (including religious boards, |

|societies and other church or church denomination).” |

|In each case the facts determine whether an individual is duly ordained, commissioned or licensed, since religious |

|disciplines vary in their formal procedures in these areas. For example, the Tax Court in Salkov (57 TC 727) found that a |

|Jewish cantor who wasn’t ordained but who had a bona fide commission and who was employed by a congregation on a full-time |

|basis was a minister for tax purposes because he performed the religious worship, sacerdotal, training and educational |

|function as specified by Jewish religious tenets. |

|However, in Lawrence (50 TC 494) the Tax Court found that a minister of education in a Baptist church didn’t qualify for |

|special tax treatment because he was commissioned but not ordained and wasn’t able to officiate at baptisms or the Lord’s |

|Supper or to preside over or preach at worship services. Youth ministers, ministers of education or other special-function |

|ministers may find themselves in this same situation. CPAs must take into account the duties of clerics with regard to |

|sacraments and worship when making the determination of whether they qualify as “ministers of the gospel.” |

|EMPLOYEES OR SELF-EMPLOYED? |

|The determination of whether a cleric is an employee or self-employed for federal income tax purposes is based primarily on |

|fact. Most probably are employees under the current tests used by the IRS and the courts. From a tax-planning standpoint, |

|they generally are better off being classified as employees than as self-employed persons for several reasons. First, |

|classification as an employee allows the value of various fringe benefits available to employees—such as employer-paid health|

|insurance premiums, life insurance premiums and contributions to retirement plans—to be excluded from income. Second, as |

|employees, most clerics can be reimbursed by their organization for business expenses without any income tax consequences as |

|long as the reimbursement is through an “accountable plan.” Reimbursements under an accountable plan are especially |

|beneficial to clerics subject to the alternative minimum tax (AMT). The amount of the reimbursement is not included in income|

|and there is no AMT adjustment for the related expenses since they are not deducted as miscellaneous itemized deductions. |

|Finally, clerics are less likely to trigger an IRS audit with employee status. According to a GAO report in 2001, audit risk |

|is much higher for self-employed persons than for employees. |

|The downside of being considered an employee for federal income tax purposes is that unreimbursed employee business expenses |

|are subject to a 2% of adjusted gross income (AGI) floor and must be reported on schedule A. Clerics who do not itemize thus |

|will lose any deduction for unreimbursed employee business expenses. |

|Generally, someone is an employee if the employer has the legal right to control both what the individual does and how the |

|work is performed. However, there are a few situations in which a cleric is more likely to be classified as self-employed |

|rather than as an employee for federal income tax purposes. For example, itinerant evangelists usually conduct services in |

|several different churches during the course of a year and ordinarily are self-employed. Guest speakers also are usually |

|self-employed as are ministers on temporary assignment to a church. Clerics who are employees may be self-employed for |

|certain services such as baptisms, bar mitzvahs, weddings and funerals. These services usually are performed directly for |

|church or temple members who pay a fee to the cleric. |

|Members of the clergy who work without direct control and supervision may think they are self-employed. However, the Tax |

|Court in James (25 TC 1296) stated that “despite this absence of direct control over the manner in which professional men and|

|women shall conduct their professional activities, it cannot be doubted that many professional men and women are employees.” |

|Whether they are classified as employees or as self-employed for federal income tax purposes, clerics are exempt from federal|

|tax withholding. However, those who are classified as employees can request that their income taxes and self-employment taxes|

|be withheld from their salary payments, and CPAs should advise them to do so. If they don’t, members of the clergy must make |

|quarterly estimated payments for federal income taxes and self-employment taxes to avoid penalties for underpayment of taxes.|

|RESOURCES |

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|[pic]Church & Clergy Tax Guide by R. Hammer, 2004 edition, Christian Ministry Resources, Matthews, North Carolina, 2003. |

|[pic] provides some free useful information. |

|[pic]IRS Audit Guide, Ministers: Market Segment Specialization Program. |

|[pic]IRS Publication 533, Self-Employment Tax. |

|[pic]IRS Publication 517, Social Security and Other Information for Members of the Clergy and Other Religious Workers. |

|[pic]IRS Publication 1828, Tax Guide for Churches. |

|[pic]IRS Publication 17, Your Federal Income Tax. |

|All IRS publications can be found at . |

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|CLERGY BUSINESS EXPENSES |

|Clerics who are classified as employees may be reimbursed for business expenses such as meals, travel, office supplies, and |

|robes and vestments. However, for the reimbursement to be excluded from income, it must be made under an accountable plan, |

|that is, an arrangement that requires a business purpose for all reimbursements, substantiation within a reasonable period of|

|time and reimbursement of any payments in excess of substantiated business expenses to the employer within a reasonable |

|period of time. |

|Business expenses that are not reimbursed under an accountable plan or that are in excess of the amounts allowed under such |

|plans are deductible on form 2106 for employees and on schedule C for self-employed taxpayers. A common business expense for |

|clergy is travel; deductions can be taken for trips to hospitals or nursing homes, conferences and meetings in town or out of|

|town, and any other business-related travel. Clergy face the same deductibility limitations on travel, meals, entertainment |

|and lodging as do other taxpayers. Travel to and from their houses of worship, for example, is considered a commuting expense|

|and is nondeductible. |

|Clergy also may have other deductible business expenses related to their profession. Purchasing supplies or paying renewal |

|fees for maintaining credentials are valid deductible business expenses, as are telephone expenses for business purposes and |

|deductions for special robes or vestments. If a cleric is an employee, reimbursements under nonaccountable plans must be |

|reported as income. Business expenses then are deductible as miscellaneous itemized deductions subject to the 2% of AGI |

|floor. These expenses generally are reported on form 2106, or for self-employed ministers, on schedule C. |

|Regardless of whether a cleric is an employee and deducting business expenses on form 2106 or self-employed and deducting |

|business expenses on schedule C, some percentage of business expenses will not be deductible in most cases. If a cleric’s |

|compensation includes a parsonage or housing allowance, which is excludable from gross income, the nondeductible business |

|expense percentage is based on the ratio of the clergy’s nontaxable to taxable income. CPAs can find detailed examples and |

|worksheets in IRS Publication 517, Social Security and Other Information for Members of the Clergy and Other Religious |

|Workers. |

|Not all expenses are deductible, though. Deductions for a home office rarely are allowed since churches and temples usually |

|provide an office, and parsonage allowances already are excluded from income. Contributions made by clerics to their |

|congregations also are not classified as business expenses but are deductible as itemized charitable deductions on schedule |

|A. Business suits aren’t deductible since they can be worn outside of work, and dry-cleaning expenses also can’t be deducted.|

|GIFTS AND COMPENSATION |

|Many clerics mistakenly believe that special offerings or bonuses they receive are gifts when in fact the IRS views these as |

|compensation for services rendered. The definition of a gift for tax purposes is “proceeding from a detached and |

|disinterested generosity…out of affection, respect, admiration, charity or like impulses. The most critical consideration…is |

|the transferor’s intention.” Therefore, gross income for clergy includes compensation, bonuses and “special gifts” that have |

|been made out to the church, temple or mosque and then given to the cleric, or for which a parishioner or member is taking a |

|charitable deduction. It also includes expense allowances for travel, transportation or other business expenses received |

|under a nonaccountable plan and amounts paid to cover a cleric’s self-employment or income taxes. Payments made for spousal |

|travel are taxable as income unless the spouse was required to travel for religious business purposes. |

|Fees paid directly to the cleric for performing ceremonies such as weddings, bar mitzvahs, funerals, baptisms and masses all |

|are includable in income on schedule C as self-employment income even if the cleric is an employee. Fees given directly to |

|the congregation rather than to the cleric aren’t considered compensation to the cleric unless the congregation then writes a|

|check out to him or her. Contributions made to or for the support of individual missionaries are includable as gross income |

|to the missionaries. |

|SELF-EMPLOYMENT TAXES FOR CLERGY |

|Members of the clergy always are self-employed for Social Security purposes even if they are treated as employees for federal|

|income tax purposes. Thus, a cleric pays 12.4% for Social Security on income up to $87,900 for 2004 and 2.9% for Medicare on |

|all self-employment income just like everyone else. Earnings for self-employment taxes include the total compensation such as|

|salary and any parsonage or housing allowance reduced by business expenses, whether unreimbursed or reimbursed under a |

|nonaccountable plan. In addition, one-half of the self-employment tax (computed without regard to this deduction) can be |

|deducted in computing net earnings from self-employment. Also, half of an individual’s self-employment tax is deductible in |

|arriving at adjusted gross income when computing federal income taxes. |

|Clerics may file for an exemption from self-employment tax under certain circumstances. For example, those who |

|conscientiously object to, or whose religious principles oppose, the acceptance of public insurance (for example, benefits |

|established by the Social Security Act) may file for an exemption under section 1402(e)(1). However, the exemption is valid |

|only if approved by the IRS. CPAs can find the requirements for the exemption in IRS Publication 517. |

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|PRACTICAL TIPS TO REMEMBER |

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|When advising members of the clergy, CPAs should |

|[pic]Recommend that compensation packages above $125,000 be reviewed by the board and that documentation be reviewed to make |

|sure compensation is reasonable. |

|[pic]Check out revised IRS Publication 1828, Tax Guide for Churches, for some limited guidance on who is a minister. While |

|the issue is critical, the IRS has provided little other advice on the subject. |

|[pic]Consider classifying clergy as employees rather than self-employed to take advantage of nontaxable fringe benefits such |

|as health insurance, life insurance, employer-provided retirement plans and a lower IRS audit risk. |

|[pic]Advise the church, temple or mosque to adopt an accountable reimbursement arrangement if an accountable plan is used for|

|business expenses. Be sure the cleric has sufficient evidence to substantiate the amount, date, place and business purpose of|

|the expense. |

|[pic]Remind clerics that “love offerings,” bonuses and other gifts are taxable income. |

|[pic]Encourage organizations that offer “denominational plans” to designate that a part of the benefit be used as housing |

|allowance, which will be excluded from both income tax and self-employment taxes of the cleric in retirement. |

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|CLERGY RETIREMENT PLANS |

|A number of tax-favored retirement plans available to clergy include the same types that are available to all employees, as |

|well as some unique plans and features. Common types of retirement plans include individual retirement accounts (both Roth |

|and regular), tax-sheltered annuities (403(b) plans), qualified pension plans, 401(k) plans, simplified employee plans (SEPs)|

|and “Rabbi trusts.” Self-employed clergy also may establish Keogh plans. |

|One unique plan for clergy whose features CPAs should be aware of is the “Rabbi trust” arrangement, which allows a religious |

|organization to transfer assets into a trust whose income and principal will be paid to the clergy upon retirement. IRS |

|letter ruling 8113107 concluded that the transfer of the assets into such a trust didn’t cause a taxable transaction for the |

|beneficiary. If the guidance provided in revenue procedure 92-64 is followed, this is an effective way for CPAs to defer the |

|taxation on the transfer of assets until they actually are paid to the beneficiary. |

|Denominational plans or retirement plans such as 403(b)s or SEPs established by religious denominations for their clerics |

|also offer significant opportunities. These plans can be funded by the employing organization, but even if they are |

|completely funded by the cleric, they provide attractive benefits that aren’t available with other retirement plans. The |

|significant benefit of such plans is that taxpayers can declare that a part of the benefit is for a housing allowance for the|

|retired cleric, thereby sheltering a portion of the retirement benefits from taxation. In addition Congress in 1996 excluded |

|the parsonage allowance from self-employment taxes after the cleric retires, making denominational plans especially |

|attractive. |

|CLERGY’S UNIQUE TAX ISSUES |

|Members of the clergy face a wide variety of tax complexities and can benefit greatly from expert tax advice in the areas of |

|housing exemption allowance, employee vs. self-employed status, business expenses, self-employment taxes, gifts and |

|compensation and retirement plan options. Sound tax planning advice can help them reap the tax benefits afforded their |

|profession under the Internal Revenue Code. [pic] |

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