Source: http://www.americanbar.org/publications/gpsolo_ereport/2012/december_2012/tax_considerations_ministers_employees_religious_organizations.html
Timestamp: 2013-05-22 13:50:49
Document Index: 570210830

Matched Legal Cases: ['§ 31', '§ 3102', '§ 3401', '§ 3402', '§ 6315', '§ 3121', '§ 3121', '§1402', '§ 3121', '§ 1402', '§ 1402', '§ 1402', '§ 3301', '§ 3309']

Special Tax and Other Considerations for Employees of Religious Organizations | Solo, Small Firm and General Practice Division
Lisa A. Runquist is an attorney in Los Angeles, California, specializing in representing nonprofit organizations. She was the first winner of the Outstanding Lawyer Award (Nonprofits), and first to win both that and the Vanguard (Lifetime Achievement) Award from the ABA Business Law Section. She has authored numerous publications on nonprofit and religious organizations, including The ABC’s of Nonprofits (author; ABA 2005) and Nonprofit Resources (ed., ABA 2007). She has been active in both California State Bar and ABA Business Law Section Committees relating to tax-exempt and nonprofit organizations. She served as chair of the California State Bar’s Nonprofit and Unincorporated Organizations Committee and chair of the ABA Business Law Section’s Nonprofit Organizations Committee. She serves as ABA Liaison to the ALI/ABA Principles of the Law of Nonprofit Organizations, and was the ABA Advisor to the ULC Uniform Unincorporated Nonprofit Association Act (finalized 2008) and to the ULC Model Protection of Charitable Assets Act (finalized 2011).
Learn about the tax status of ministers.Learn how to treat a parsonage. From Guide to Representing Religious Organizations, Chapter 6 Churches have the right to choose their ministers, free from the interference of government. Nevertheless, in addition to the general employment and tax law that applies to religious organizations, there are some specific issues about which religious organizations need to be aware, especially with regard to their ministers. Many, but not all, are tax related.As noted in the glossary, we use the term “minister” to refer to all members of the clergy of all religions and denominations including priests, rabbis, imams, and similar leaders of congregations or groups of worshipers. I. Is a Minister an Employee or Self-employed for Income Tax Purposes?Appendix A to this chapter discusses the distinctions between an employee and an independent contractor. With ministers, this question of whether they are employees or independent contractors has caused controversy over the past 20 years. It is a significant question for many reasons:(1) Employees are required to report their annual compensation directly on Form 1040 and can claim unreimbursed business expenses on Schedule A only if they itemize deductions, and then only to the extent that such itemized expenses exceed 2% of adjusted gross income and are limited to claiming only 80% of business meals and entertainment expenses. Self-employed persons, on the other hand, report compensation and business expenses on Schedule C. Business expenses are deductible whether or not the individual itemizes deductions, and are not subject to the 2% floor.(2) Adjusted gross income tends to be higher if an individual reports as an employee, since unreimbursed business expenses of employees are deductions from adjusted gross income. Self-employed persons deduct all business expenses in computing adjusted gross income. This adjusted gross income figure is important because the percentage limitations on deductions for charitable contributions and medical expenses are tied to adjusted gross income.(3) The forms used are different. Individuals should receive a Form W-2 each year if they are employees, and a Form 1099MISC if they are self-employed.(4) Retirement benefits offered by some nonprofits may only be available to employees.(5) Disability pay exclusion is available only to those having “employee” status.(6) Once an “employee” status is adopted by issuance of a W-2 Form, it cannot be reversed in the eyes of the I.R.S.For many years, most ministers reported their income taxes as self-employed persons. This was consistent with the treatment of all ministers as self-employed for Social Security purposes, and as not being subject to employee withholding requirements (see below). In 1978, the Internal Revenue Service (IRS) made statements that were interpreted by some to require ministers to report their income as employees. In one ruling, the IRS held that a minister who is “an employee of a church” may not deduct unreimbursed business expenses on Schedule C but rather must use Schedule A.1 In Publication 517 (Social Security for Members of the Clergy and Religious Workers), the IRS lists a comprehensive example demonstrating how a minister who is an “employee of the church” should report his income and business deductions. These pronouncements led some to conclude that the IRS now views all ministers serving local churches as employees rather than as self-employed. Reliance has also been placed on section 3401(a)(9) of the Internal Revenue Code (IRC), which states that ministers who are “employees of a church” are exempt from tax withholding.While the 1978 I.R.S. pronouncements state the appropriate manner of reporting income and deductions if employee status is assumed, they are not IRS directives requiring all ministers to report their taxes as employees. In fact, Publication 517 recognizes that it is possible for ministers who are employees of their churches to be self-employed with respect to certain services, and no one has seriously questioned whether full-time evangelists are self-employed for income tax purposes. It is, therefore, impossible to generalize that all ministers are employees for income tax purposes. The most sound analysis of this issue leads one to conclude that ministers should be treated as employees if they satisfy the common law employee test adopted by the U.S. Treasury Department in Treas. Reg. § 31.340(c)1(b).2 The IRS and the courts have adopted several different tests over the years, in an attempt to enumerate various factors that are determinative of the employment relationship between ministers and churches. For example, Revenue Rule 87-41 lists 20 factors to be used in making this determination, while the U.S. Tax Court has used a seven-factor test.3 The main issue to which these multi-factor tests point is whether the church has sufficient control over the minister such that he/she can be considered an employee, which is the primary indicative factor of the common law employee test.Another important factor that can determine the employee status of a minister is the parties’ own characterization of their relationship. For example, if a church and its minister enter into a written contract that specifically characterizes the minister as self-employed, this would be an additional factor to consider in favor of characterizing the minister as self-employed for federal tax purposes.There is no doubt that many ministers will be employees under the “common law employee test” discussed above. In fact, since 1978, many denominations have formally taken the position that their ministers are employees. Such a classification may avoid the higher risk of audit and the potential cost of reclassification, should the IRS find the minister to be, in fact, an employee. However, such a conclusion is not automatic. Traveling evangelists ordinarily are self-employed, as are ministers of local congregations with respect to certain personal services rendered directly to church members (baptisms, marriages, funerals, etc.).The IRS has suggested that if a church treated a previous minister, in a substantially similar position, as an employee for any period after 1977, then no minister can be treated as self-employed by that church.4 Prior ministers were treated as employees if the church issued them a W-2, or included their wages on Form 941 or 941E. The same rule applies to a minister who at any time after 1977 was treated as an employee by his or her church.However, ministers of local congregations may be self-employed with respect to their services on behalf of the church, provided that they are not and have not previously been treated as “employees” under the common law employee test. There have been cases going both ways. For example, the Tax Court held that an ordained minister for the United Methodist Church was an employee and thus not entitled to deduct his business expenses on Schedule C.5 But, in another case decided the same year, the Court of Appeals found that an ordained minister of the Assemblies of God Church was an independent contractor.6In summary, a minister’s reporting status for federal income tax purposes will be determined on the basis of the common law employee test, as discussed in Appendix 6-A. Ministers who believe they are self-employed should have their church so characterize them in their corporate minutes and should have the church issue them a Form 1099 rather than a Form W-2 at the end of each calendar year.It should be emphasized that although treatment of an employee means that employee expenses are only deductible on Schedule A rather than Schedule C, there still remain many significant benefits to being treated as an employee, including the ability of the church to include the pastor in the church cafeteria plan and the reduced risk of audit. II. Employment Taxes and ReportingA. Withholding—Non-Minister EmployeesGenerally, a church, like any other employer, is required to deduct taxes from the wages of employees.7 Therefore, church employees, other than ministers, are subject to withholding.Employers are not required to withhold taxes from payments to persons performing services as independent contractors. Independent contractors are persons who are in business for themselves and offer their services to the public. B. Withholding—MinistersAs an exception to the general rule of withholding for employees, employers are not required to withhold taxes for “services performed by a duly ordained, commissioned or licensed minister of a church in the exercise of his ministry.”8 Therefore, a church does not have to withhold income taxes from compensation paid to the pastor.However, if both the church and the minister agree, a minister may enter into an agreement with the church to withhold and pay income tax. The agreement may be terminated at any time by mutual consent.9 If the church does not withhold, the minister must pay quarterly estimated taxes.10 C. Social Security—EmployeesBefore 1984, churches were exempt from withholding Social Security (FICA) taxes and from paying the employers share thereof. Effective January 1, 1984, the IRC was amended to provide that a church or qualified church organization that is “opposed for religious reasons to the payment of the tax” may file an election to be excluded from payment of the tax.11 Under that section, a church that was already an employer on July 1, 1984, had to file a Form 8274 with the IRS before October 30, 1984, in order to remain exempt. Churches that did not have employees at that time must file (or have filed) the form prior to the due date of their first employer quarterly return. Churches that have declared themselves exempt may revoke their exemption after 1986, but the law does not specify the procedure for revocation.12If a church has made this election, it does not have to withhold FICA taxes from the salaries of its nonminister employees. However, the nonministry employees are then required to pay their own Social Security tax at the self-employed rate (generally equal to the combined employer and employee rate).13 D. Social Security—MinistersWhether they are determined to be employees or independent contractors for other purposes, ministers are always treated as self-employed with respect to the Social Security program.14 In other words, a minister will never be included in FICA; he/she is subject to the Self Employment Contributions Act (SECA) unless he/she elects out as is discussed below. SECA provides that a “duly ordained, commissioned or licensed minister of a church in the exercise of his ministry” is to be treated as self-employed for purposes of Social Security even if he is considered to be an employee for income tax or other purposes.15Unless the minister elects to be exempt as set forth below, a minister must attach Schedule SE to his or her annual income tax return and pay the full amount of the Social Security tax on his NET income received from the ministry.This net income includes the parsonage housing allowance. Even though a minister can exclude the parsonage allowance in computing his income tax, he or she must include that amount in computing his or her self-employment tax.16 However, once a minister retires, the rental value of any parsonage or parsonage allowance received is not subject to SECA.Members of a religious order are considered to be self-employed for purposes of Social Security, the same as ministers. They may apply for Social Security tax exemption in the same manner as ministers. Although members of a religious order often take a vow of poverty, they are still taxed on income earned from any outside occupation. However, the amount of any earnings turned over to the order may be treated as a charitable contribution. E. Social Security Exemption—PastorsA minister is permitted to withdraw from Social Security coverage if:a. The minister is ordained, licensed or commissioned.b. The church ordaining the minister is qualified as a tax exempt religious organization.c. The minister affirms that he or she is opposed to coverage because of religious principles.d. The minister has informed the ordaining, commissioning or licensing body of this opposition, because of religious principles, to the acceptance of any public insurance.e. The minister has not filed an effective waiver certificate, electing to be covered (Form 2031).f. The exemption application (Form 4361) is filed within two years from the date the minister’s tax return is due on self-employment income of $400.00 or more. This two-year period cannot be changed. If the two years pass without an application being filed, the opportunity to be exempt expires.If a pastor applies for exclusion from the self-employment program and the church in which he was ordained or the church from which he receives compensation has not received an exempt determination letter from the IRS, his or her application is likely to be rejected unless the IRS can be shown that the church is exempt under 501(c)(3) of the IRC. This can be done either by filing an application for an exempt determination letter, or by filing Form 8123 with the IRS.If a pastor chooses to elect out, the exclusion will apply only to compensation received as a pastor. Wages received in any other capacity are not exempt.Members of a religious order who are under a vow of poverty are exempt from the Social Security program. Members of a religious order not under a vow of poverty are considered self-employed for purposes of the Social Security program, and can file an application to be considered exempt from self-employment, in the same manner as a minister. F. Revocation of ElectionAbout every 10 years, there have been efforts to bring pastors back into the Social Security system. The last open window that allowed pastors who elected out of the Social Security system to elect back in, required that Form 2031 be filed no later than April 15, 2002. It is not clear whether or not this revocation of election will be available in the future. G. Unemployment TaxIn addition to having to withhold and pay income tax and Social Security taxes, employers are also required to pay unemployment taxes, computed as a percentage of their total payroll.17 However, unemployment taxes are not payable on services performed:(1) [by persons] in the employ of (A) a church or convention or association of churches or (B) an organization which is operated primarily for religious purposes and which is operated, supervised, controlled or principally supported by a church or convention or association of churches(2) by a duly ordained, commissioned or licensed minister of a church in the exercise of his ministry or by a member of a religious order in the exercise of duties regulated by such order.18This means that churches are exempt from Federal unemployment tax (FUTA).Prior to 1976, elementary and secondary schools were also exempted. An amendment in 1976 removed the exemption. In 1978, the U.S. Secretary of Labor announced that this amendment required church schools to be covered. A number of church operated elementary and secondary schools challenged the Secretary of Labor’s interpretation.In St. Martin Evangelical Lutheran Church v. South Dakota,19 the U.S. Supreme Court ruled that employees of schools that have no separate legal existence from a church are exempt from the unemployment tax. The Court declined to rule that application of the tax to church run schools was violative of the First Amendment. The Court ruled that Congress intended the exemption to apply since there was no difference between employees of a church and employees of a church run elementary or secondary school.Church schools that have a separate legal existence may also be exempt from unemployment taxes:To establish exemption from FUTA, a separately incorporated church school (or other organization) must satisfy the requirements of Section 3309(b)(1)(B): (1) that the organization “is operated primarily for religious purposes,” and (2) that it is “operated, supervised, controlled, or principally supported by a church or convention or association of churches.20In 1988, the U.S. Secretary of Labor issued a directive that schools run by a church or group of churches would be exempt from FUTA (even if separately incorporated), but that schools not directly connected to a church would have to be covered.21 III. ParsonageIRC Sec. 107 provides that a minister may exclude from his gross income a specified parsonage allowance used to rent or otherwise provide a home. Treas. Reg. 1.107 1(b) provides in relevant part:The term “rental allowance” means an amount paid to a minister to rent or otherwise provide a home . . . if such an amount is designated as rental allowance pursuant to official action taken in advance of such payment by the employing church or other qualified organization. . . . The designation of an amount as rental allowance may be evidenced in an employment contract, in minutes of or in a resolution by a church or other qualified organization or in its budget, or in any other appropriate instrument evidencing such official action. The designation . . . is a sufficient designation if it permits a payment or a part thereof to be identified as a payment of a rental allowance as distinguished from salary or other remuneration. (Emphasis added.)Thus, there are two requirements that the religious organization must meet for the amount to qualify. First, the designation must be made by a “church or other qualifying organization.” Second, the rental allowance must be “designated in advance” of the payment to the minister.22 A. Church or Other Qualifying OrganizationThere is no precise definition of what constitutes a church. See discussion of the term “church” in Chapter 1. Neither is there a precise definition of what constitutes another “qualified organization.” As the court observed in Warnke v. United States:Regulation 1.107 1(b) does not contain any definition or explanation for the term “qualified organization.” The lack of a statutory or regulatory definition for the term suggests the term is to be given meaning on a case by case basis.23“Integral agencies” of churches or religious organizations are deemed to be qualified organizations.24 However, the term “religious organization,” itself, is undefined by the IRC or regulations.The extent to which organizations other than churches and integral agencies can designate rental allowances has not been determined by the courts or the IRS. B. Official DesignationThe official designation of rental allowance by a church or other qualified organization need not be in writing. In M. L. Libman,25 the court upheld an oral designation by the United Jewish Appeal on behalf of a Jewish rabbi. However, because of the language of Treas. Reg. 1.1071(b), it is strongly suggested that any designation be in writing.If there is no advance designation by a church or other qualified organization, the exclusion will be lost to the minister.26 C. Eligible MinistersA church can only designate and pay a parsonage allowance to a minister who meets certain qualifications. IRC Section 107 refers to a “minister of the gospel.” In spite of this language that appears to favor a particular religion, it applies to anyone in a similar position. In discussing this, Treas. Reg. 1.107 1(a) provides that the minister must perform services that are “ordinarily the duties of a minister of the gospel” such as “performance of sacerdotal functions, conduct of religious worship, the administration and maintenance of religious organizations and their integral agencies, and the performance of teaching and administrative duties at theological seminaries.”Although there is some confusion,27 it appears that (1) a minister must have some sort of ordination, licensing or commissioning and (2) he/she must actually be performing ministerial functions, rites or ceremonies to qualify for parsonage allowance. D. Computing Parsonage AllowanceThe organization must designate the amount of the minister’s parsonage allowance in advance. The organization should have the minister report, in advance, the amount of allowable parsonage expected to be incurred. The organization may then designate that amount, plus an additional amount for unexpected expenses, as parsonage allowance for that minister.The minister must include in income any amounts designated but not actually spent. Therefore, there is no penalty to church or minister for over-designation. However, any amounts in excess of fair market value must be returned to the organization or declared as income by the minister. The amount that can be excluded is also now limited by the fair rental value of the house and its furnishings. Endnotes1. Rev. Rul. 80-110. See also Rev. Rul. 79-78.2. See chapter 5, Appendix 5-A.3. Weber v. Comm’r, 103 T.C. 378 (1994), and Shelly v. Comm’r, T.C. Memo. 1994-432(1994).4. See Rev. Proc. 85-18.5. Henry W. Radde, et al. v. Comm’r, T.C. Memo 1997-490 (1997).6. Alford v. United States, 1997 TNT 121-34, 79 AFTR 2d Par. 97-1045 (1997).7. I.R.C. §§ 3102 and 3402(a).8. I.R.C. § 3401(a)(9).9. I.R.C. § 3402(p).10. I.R.C. § 6315 et seq.11. I.R.C. § 3121(w)(1).12. I.R.C. § 3121(w)(2).13. I.R.C. §1402(j).14. I.R.C. § 3121(b)(8)(A), I.R.C. § 1402(a)(8).15. I.R.C. § 1402(c).16. I.R.C. § 1402(a)(8).17. I.R.C. § 3301.18. I.R.C. § 3309(b).19. 451 U.S. 772 (1981).20. Id. at 782-83, note 12.21. Some state unemployment insurance laws do not follow the same standards as FUTA, and therefore may not exempt churches or their affiliates.22. See Treas. Reg. 1.107-1(b).23. 641 Fed. Supp. 1083, 1091 (1986).24. I.R.S. Rev. Rul. 72606.25. M. L. Libman, 44 T.C.M. 370, Dec. 39 (161)(M), T.C. Memo. 1982377.26. Warnke, supra, Ling v. United States, 200 Fed. Supp. 282 (D.C. Minn. 1961), Eden v. C.I.R., 41 T.C. 605 (1964).27 Rev. Rul. 59-270, 1959-2 C.B. 44.
Did you find this article helpful? Do you think more information like this would help you? More information is available. This material is excerpted from Guide to Representing Religious Organizations, 2008, edited by Lisa A. Runquist, published by the American Bar Association Business Law Section and available to members of the Business Law Section for a discounted price through the link provided at the end of this article. Copyright © 2008 by the American Bar Association. Reprinted with permission. All rights reserved. This information or any or portion thereof may not be copied or disseminated in any form or by any means or stored in an electronic database or retrieval system without the express written consent of the American Bar Association. Business Law Section members can purchase this book at a discount.