What should church leaders note before structuring compensation plans? Compensation planning for clergy and other church staff presents several unique tax issues that are not well understood by many church leaders and their advisers. Here are three quick key considerations to review when structuring compensation plans:

1. Salary

The most basic component of church staff compensation is salary. There are two important considerations to keep in mind with respect to staff salaries—the amount of the salary and the use of “salary reduction agreements.” If a church pays unreasonably high compensation to a pastor or other employee, the church may lose its tax-exempt status or face intermediate sanctions, including tax on disqualified persons, additional tax on disqualified persons, and tax on organization matters.


Churches that pay a minister (or any staff member) significantly more than the highest 25 percent for comparable positions should obtain a legal opinion from an experienced tax attorney confirming that the amount paid is not “unreasonable” and will not expose the employee or the board to intermediate sanctions.

Many churches have established “salary reduction agreements” to handle certain staff expenses. The objective is to reduce an employee’s taxable income since only the income remaining after the various “reductions” is reported on the employee’s W-2 at the end of the year. It is important for churches to understand that they cannot reduce an employee’s taxable income through salary reductions unless specifically allowed by law. Three ways that taxable income can be reduced through salary reduction agreements: (1) Tax-sheltered annuity contributions, (2) “Cafeteria plans,” and (3) Housing allowances.

2. Housing and equity allowances

The most important tax benefit available to ministers who own or rent their homes is the housing allowance. Ministers who own or rent their home do not pay federal income taxes on the amount of their compensation that their employing church designates in advance as a housing allowance to the extent that the allowance represents compensation for ministerial services, is used to pay housing expenses, and does not exceed the annual fair rental value of the home (furnished, plus utilities). Housing-related expenses include mortgage payments, rental payments, utilities, repairs, furnishings, insurance, property taxes, additions, and maintenance.

Ministers who live in a church-owned parsonage that is provided “rent-free” as compensation for ministerial services do not include the annual fair rental value of the parsonage as income in computing their federal income taxes. The annual fair rental value is not “deducted” from the minister’s income. Rather, it is not reported as additional income anywhere on Form 1040 (as it generally would be by non-clergy workers). Further, ministers who live in a church-provided parsonage do not pay federal income taxes on the amount of their compensation that their employing church designates in advance as a parsonage allowance, to the extent that the allowance represents compensation for ministerial services and is used to pay parsonage-related expenses such as utilities, repairs, and furnishings.

Note that the parsonage and housing allowance exclusions only apply in computing federal income taxes. Ministers cannot exclude them when computing their self-employment (Social Security) taxes.


Be sure that the designation of a housing or parsonage allowance for the subsequent year is on the agenda of the church board for one of its final meetings of the current year. The designation should be an official action of the board or congregation, and it should be duly recorded in the minutes of the meeting. The IRS also recognizes designations included in employment contracts and budget line items—assuming in each case that the designation was duly adopted by the church board (or the congregation in a business meeting). Also, if the minister is a new hire, be sure the church designates a housing allowance prior to the date he or she begins working.

Ministers who live in church-owned parsonages are denied one very important benefit of home ownership—the opportunity to accumulate “equity” in a home over the course of many years. Many ministers who have lived in parsonages during much of their active ministry often face retirement without housing. To avoid the potential hardship of no equity and no housing, some churches increase their minister’s compensation as an “equity allowance” to provide the equivalent of equity in a home. This is an excellent idea that should be considered by any church having one or more ministers living in church-provided housing. The equity allowance should not be accessible by the minister until retirement, so it should be placed directly in a minister’s tax-sheltered retirement account.

Equity allowances also should be considered by a church whose minister rents a home.

3. Accountable Business Expense Reimbursement Policy

Under such an arrangement, a church (1) reimburses only those business expenses that are properly substantiated within a reasonable time as to date, amount, place, and business purpose, and (2) requires any excess reimbursements (in excess of substantiated expenses) to be returned to the church. Churches should seriously consider adopting an accountable reimbursement policy for reimbursing staff business expenses. Such a policy has the following advantages:

  • Church staff reports their business expenses to the church rather than to the IRS.
  • Church staff who report their income taxes as employees, or who report as self-employed and who are reclassified as employees by the IRS in an audit, avoid the limitations on the deductibility of employee business expenses. These limitations include (1) the elimination of any deduction if the employee cannot itemize deductions on Schedule A (most taxpayers cannot), and (2) the deductibility of business expenses on Schedule A as an itemized expense only to the extent that these expenses exceed 2 percent of the employee’s adjusted gross income.
  • The so-called Deason allocation rule is avoided. Under this rule, ministers must reduce their business expense deduction by the percentage of their total compensation that consists of a tax-exempt housing allowance.
  • The “50 percent limitation” that applies to the deductibility of business meals and entertainment expenses is avoided. Unless these expenses are reimbursed by an employer under an accountable plan, only 50 percent of them are deductible by either employees or self-employed workers.
  • Church staff who report their income taxes as self-employed avoid the risk of being reclassified as an employee by the IRS in an audit and assessed additional taxes.

This excerpt was adapted from the 2012-2013 Compensation Handbook for Church Staff (Christianity Today) available at YourChurchResources.comUsed with permission.