Few issues are as misunderstood, abused and confused as the tax implications of a pastor’s salary. The issue is so different from compensation in the business world that some CPA’s have given errant advice to pastors. Add into this the fact that many churches approach compensation differently and use different terminology. All in all, we have a thoroughly confusing issue.
Many pastors make mistakes the first year and have huge tax bills due on April 15. Other pastors miss out on potential savings and overpay their taxes for years. If you know the law, then you can make use of the special provisions for substantial tax savings! Let’s begin with a simple definition and then get to the tough issues.
Does Caesar Recognize the Pastor?
For tax issues, the first consideration is the IRS definition of a pastor. Now, this is not the Bible’s definition of a pastor. The apostle Paul, in Ephesians 4:11-13, gives a classic biblical definition of the work of the pastor:
It was he who gave some to be apostles, some to be prophets, some to be evangelists, and some to be pastors and teachers, to prepare God’s people for works of service, so that the body of Christ may be built up until we all reach unity in the faith and in the knowledge of the Son of God and become mature, attaining to the whole measure of the fullness of Christ.
The Bible needs to be our starting point for church life. The importance here is that we are not talking about the spiritual gift of pastoring people, but the government’s recognition of the office of a pastor. In the public arena, we need to “render unto Caesar what is Caesar’s.” There are many ways to be taxed by Caesar:
- Federal income tax (10-35% of your salary).
- Social Security tax, which is really two items, Social Security and Medicare (7.65% of your salary) plus the employer’s contribution of another 7.65%.
- Real estate tax (1-3% of the value of your home).
- Sales tax (6-8% of the sales price).
- Other taxes, such as automobile registration or airport tax in your airline ticket.
Just as we pay taxes to be good citizens, also for tax purposes we follow Caesar’s definition of a pastor or minister. If you don’t like the tax code, no problem—just pay your taxes and don’t take the special deductions that come to ministers!
Concerning taxable income, the Internal Revenue Service is quite helpful in explaining our complex tax code. For this article, unless otherwise noted, all citations will come from IRS Publication 517. Check out the IRS website at www.irs.gov for plenty of information. Here is how the IRS defines a minister:
Ministers are individuals who are duly ordained, commissioned, or licensed by a religious body constituting a church or church denomination. They are given the authority to conduct religious worship, perform sacerdotal functions, and administer ordinances or sacraments according to the prescribed tenets and practices of that church or denomination. If a church or denomination ordains some ministers and licenses or commissions others, anyone licensed or commissioned must be able to perform substantially all the religious functions of an ordained minister to be treated as a minister for social security purposes.
The bottom line is that for tax purposes, a minister must be licensed, commissioned or ordained by the church and able to function as that church defines a minister.
One cannot be called “minister” and receive tax benefits but have no authority to act as a minister. The tax code also allows for special religious workers who may not fit the common perception of a minister: it allows for cantors in Jewish synagogues, traveling evangelists and teachers in religious schools, among many others. If you have a Pastor of Administration, he or she can be considered a minister if they have the authority to do the same ministry as other pastors, such as performing a marriage—whether or not they actually use that authority or not.
By the way, it’s best if your church has a list of all pastors that is annually put into the governing board’s minutes, such as when the housing allowances are approved.
Is the Pastor an “Employee?”
You might say, “The church hired me, and can fire me, so of course I am an employee.” The answer to that is “yes and no.” The IRS says:
“If you are a minister of a church, your earnings for the services you perform in your capacity as a minister are subject to SE tax unless you have requested and received an exemption.”
What does that mean? You are both an employee and a self-employed person. Does that mean that you will get the worst of both worlds? Again, yes and no! For starters, the bad news. As a self-employed person you get to pay your own SE tax.
The “SE” tax stands for “Self Employment.” In all other businesses, the employee pays 7.65% percent of salary in FICA (Federal Insurance Contributions Act) and the employer pays another 7.65%. This tax goes for Social Security (12.4%) and Medicare (2.9%).
Here’s the rub: unlike all other businesses, when paying pastors, churches don’t pay the employer portion of FICA. The church must pay FICA for all non-pastoral positions, but not for pastors! The pastor must pay all 15.3% in SECA (Self Employment Contributions Act).
A $67,000 salary goes to $56,749
The stories are myriad. The pastor is offered a salary of $67,000 and takes the position, thinking it just like any other salary. The compensation team thinks it is quite generous to offer such a salary—not realizing that the salary is $5,125 lower than one offered in business.
Then, at tax time, the pastor realizes that he must pay not only the employee portion of SE tax, but the employer portion as well, a total of 15.3%.
- From that $67,000 salary, the pastor must pay 7.65%; what a business pays in FICA for the employees, pastors pay themselves in SECA. The $67,000 salary just became $61,874. That is the original $67,000 less 7.65% or $5,125.
- From the remaining $61,874, you take out another 7.65%; what business employee’s pay in FICA, pastors pay themselves in SECA. Now the paycheck is $56,749.
- Many pastors will cry in anguish, “But I was supposed to earn $67,000 not $56,749!” Add to the woe that you must also take out federal income tax!
- Often the compensation team has no idea that the salary is $5,125 lower than one offered in business.
Since the minister is considered self-employed, he or she must pay estimated taxes on June 15, September 15, January 15 and April 15. If asked, churches can, under IRS guidelines, “pass through” the ministers tax out of each paycheck. This is just passing along the tax and the church is not technically paying it for you. Ultimately, it is the minister’s responsibility, not the church’s, to pay the tax. If you mess up, you will be sent the bill plus penalty, not the church. As a self-employed person, it is your responsibility to pay your taxes—and you have to accurately estimate your tax payments for the coming year. Talk to a tax professional or get some good software for estimating your taxes.
So, the pastor in the above illustration needs to pay $10,250 in SE tax. The pastor can use the church’s payroll process to “pass through payments to the IRS” in each paycheck or can write a personal check in four quarterly installments of $2,562. The pastor needs to pay $10,251 SE tax. And, this is just the SE tax, not counting any local, state or federal taxes.
“Bummer,” you say! “There must be a way out. ” And, there is, for some …
Opting Out of Social Security
Some ministers have opted out of Social Security. “Terrific, get me out of paying 15.3% of my salary in SE tax, that’s $10,250 every year. And they will probably be broke when I want to retire anyway.” The regulations from the IRS said one must pay SE tax “unless you have requested and received an exemption.” So, all you need to do is fill out Form 2031. That was easy! Wait, you have to read and agree to all of the terms. On Form 2031, there are five things that you must agree to. The first and most important one is that you need to agree:
I certify that I am conscientiously opposed to, or because of my religious principles I am opposed to, the acceptance of any public insurance that makes payments in the event of death, disability, old age, or retirement; or that makes payments toward the cost of, or provides services for, medical care.
To opt out of Social Security, you must have religious principles or principles of conscience that cause you to be opposed to SE tax on religious income. You can’t opt out because of financial reasons, saying “Social Security is a bad investment.”
It is important to know that if you opt out, you won’t receive any retirement payments from the government based on your church salary. Just as important, on your church salary you won’t receive any medical care payments from the government. Unless you have a great insurance plan, you won’t receive any Medicare help on that heart attack that caused an $82,000 bill.
In most church circles, the pastors that I talk to are not conscientiously or religiously opposed to public insurance. If you want to opt out of Social Security, carefully consider your opposition. Consider whether your opposition is financial, “I just don’t want to pay it,” or ethical, “I can’t take money from God’s service and give some of it to the government in retirement tax.” Some pastors opted out of Social Security years ago, before there were ethical requirements by the IRS for opting out. Talk to a CPA who is knowledgeable about ministers and Social Security issues; talk to a senior citizen who has no other healthcare than medicare.
Let me add a couple of items in conclusion on the SE tax. Some churches pay the 7.65% “employers contribution” of Social Security for their pastors. This is wonderful, yet by the tax code, this is taxable income. If your church will give this income to you, great! Just pay tax on it. Also, you can slightly reduce your SE tax with qualified un-reimbursed employee expenses—that phrase is a mouthful! See the tax guides to understand how to take this modest reduction.
Good News: The Housing Allowance
For pastors, total salary is normally the combination of base salary and the housing allowance. The IRS knows that some pastors receive a parsonage while most others don’t, and that this changes the tax implications of a pastor’s salary. Here is what the IRS says should be included in total salary:
- Salaries and fees for your qualified services.
- Offerings you receive for marriages, baptisms, funerals, masses, etc.
- The value of meals and lodging provided to you, your spouse, and your dependents for your employer’s convenience.
- The fair rental value of a parsonage provided to you (including the cost of utilities that are furnished) and the rental allowance (including an amount for payment of utilities) paid to you.
- Any amount a church pays toward your income tax or SE tax, other than withholding the amount from your salary. This amount is also subject to income tax.
Let’s focus on the housing allowance. The housing allowance can lower your federal income tax but never lowers your SE tax. The IRS says:
You can exclude from gross income the fair rental value of a house or parsonage, including utilities, furnished to you as part of your earnings. However, the exclusion cannot be more than the reasonable pay for your services. If you pay for the utilities, you can exclude any allowance designated for utility costs, up to your actual cost.
This means that if your mortgage is $23,000 a year, then you don’t have to pay federal income tax on the $23,000—but you still have to pay SE tax on it. Also, you can include utilities and other expenses. The IRS says:
If you own your home and you receive as part of your pay a housing or rental allowance, you may exclude from gross income the smallest of:
- The amount actually used to provide a home, or
- The amount officially designated as a rental allowance, or
- The fair rental value of the home, including furnishings, utilities, garage, etc.
Note carefully what can be included in the housing allowance. The IRS says in Tax Topic 417: “Generally, those expenses include rent, mortgage interest, utilities, repairs, and other expenses directly relating to providing a home.” Here are some things to consider and records to keep for tax time:
- Keep and use the end-of-year statement from your mortgage company to determine your total mortgage interest.
- Save those repair bills. Did you replace the garage door? Did you repair the roof after a hailstorm?
- The “other expenses directly relating to providing a home” is a huge category. Save the credit card statements, bills or receipts that validate your “other expenses.” Did you buy furniture? Do you want to track the purchase of cleaning supplies? The last time I checked, I’m sorry to say that it doesn’t include any kind of house help.
The timing of when the housing allowance is set is vitally important. The IRS says, “the church or organization that employs you must officially designate the payment as a housing allowance before the payment is made. A definite amount must be designated. The amount of the housing allowance cannot be determined at a later date.” This is vital! You must set the housing allowance before you can use it.
Many churches allow pastors to recommend a percentage of their total salary as the housing allowance. They will say, “We are going to pay you $67,000 and how much of that do you want to designate as a housing allowance?” It doesn’t cost the church any more or less to set a percentage of your salary as a housing allowance. Let’s see how this plays out.
Example of a $67,000 salary
With a $67,000 salary, you are going to pay $10,251 in SE tax. That is a given, so let’s have our tears and move on. But, let’s add up qualified housing allowance expenses:
- Consider that you have $20,000 in mortgage and taxes.
- Adding up your repairs comes to $3,000.
- You have $2,000 in “other expenses.”
- Utilities for the year came to $5,000.
Your total housing expenses came to $30,000:
- You will pay federal income tax on $37,000 (the $67,000 less the $30,000 in qualified housing allowance deductions).
- Not counting any other deductions, the federal tax on $67,000 is $11,259 and on $37,000 is $4,916.
- So, the housing allowance saves you $6,343. Your savings may be far greater if you have other deductions!
Here are some practical tips about the housing allowance:
- Get a housing allowance designated that is more than you think you will need. You can’t retroactively say, “Oops, I spent more on utilities than what I estimated. Can the church increase the portion of salary that you already paid me?” Always estimate your housing allowance 10-25% higher. In the example above, the pastor should have asked for a housing allowance of $33,000-$37,000. You will report the $3,000-$7,500 unused housing allowance as income on Form 1040. You didn’t use it, so you can’t have it tax-free.
- Keep track of all the money that you spend on furnishings and “other expenses.”
- Do you have house help? This is not included in your housing allowance!
- You can’t claim more than your total earnings.
- You can’t claim more than your actual expenses.
- Deduct one-half of your SE tax when you compute your adjusted gross income.
Tax rules can change, so check out the IRS website or talk to a tax advisor.
Ministers get a Double Bonus
There is a deduction for all homeowners to deduct interest payments and real estate taxes on Schedule A of Form 1040. This can apply to every taxpayer if they meet the stipulations set forth by the IRS. Ministers get a double bonus. In addition to getting the housing allowance, Ministers can itemize their interest expense and real estate tax with the rest of homeowners on Schedule A.
In the $67,000 salary example, $15,000 was spent on mortgage and another $5,000 on real estate taxes. The entire $20,000 can be entered on Schedule A. Let’s add this to the tax scenario and let’s suppose the final deduction number is $20,000:
- With a $67,000 salary, you will pay $10,250 in SE tax.
- With $30,000 in housing expenses, your adjusted gross income is $37,000.
- With $20,000 in deductions, your taxable income is $17,000 and you would pay $1,916 in federal taxes.
So, with some careful planning, work and record keeping, you can save thousands in taxes.
Other Income/Unreimbursed Expenses
Ministers often receive all sorts of other income. There is often compensation given by the family when performing a wedding or funeral. An honorarium may be given when speaking at another church. All of these things will be listed on Schedule C. These are the income items that are separate from your main employer. Schedule C has special lines to list expenses. If you do premarital counseling and purchase books, the expense can be counted against the income.
There is also a place in Schedule A of Form 1040 to enter unreimbursed expenses. You may use your car for church business (but not to and from work), and choose to not have the church reimburse you. You may have meals, gifts or travel that the church does not reimburse. You can get some tax relief from these expenses on Schedule A. It takes a fair amount of work and financial calculations to get these deductions, so be prepared to get out the spreadsheet.
I would like to tell you that this is the last and complete word on tax implications of a pastor’s salary. Unfortunately, it is only the major issues. And these things will change over time.
However, by knowing the law and carefully applying it, you can save thousands of dollars a year. By alerting our churches that pastors pay the entire 15.3% of SE tax, many churches will give compensation to equal the scales as compared to a salary in business.
- IRS Publication 517, “Social Security and Other Information for the Members of the Clergy and Religious Workers”
- IRS Tax Topic 417, “Earnings for Clergy”
- IRS Form 4361, “Application for Exemption from Self-Employment Tax for Use by Ministers, Members of Religious Orders, and Christian Science Practitioners”
- IRS FAQ 4.10, “Interest, Dividends, Other Types of Income: Ministers’ Compensation & Housing Allowance.”
This article appeared in ChurchExecutive magazine in two parts in Fall, 2007.