Special Clergy Tax Rules

 Income Tax Reporting

For many years, clergy were considered to be self-employed for income tax reporting purposes.  Local churches generally paid a pastor a single amount each month that included salary and the cost of professional expenses incurred in his/her ministry.  The church reported the whole amount paid to the pastor on Form 1099.  The pastor would file a Schedule C, Sole Proprietorship, with their Form 1040 individual income tax return.  The pastor would report the total amount received from the church (and other sources such as wedding honorariums) on Schedule C and deduct all the ordinary and necessary professional expenses of ministry to arrive at net income for Page 1 of Form 1040.

Virtually all of this changed in 1995. A Federal Appeals Court ruled in Weber vs. IRS Commissioner that Methodist pastors are Employees for income tax purposes.  This decision applies for IRS reporting purposes only.  It does not change United Methodist polity and clergy status for church purposes, including the appointment process.

While the Weber case has had substantial impact, there are many tax issues that have not changed:

  • Clergy continue to be considered self-employed for purposes of Social Security and Medicare taxes, based on a federal statute unrelated to income tax issues.
  • The Weber decision did not affect the housing allowance; any amounts properly set up in advance and paid for housing and utilities are still not taxable income for income tax purposes (but are subject to Social Security Tax).
  • Clergy should continue to use Schedule C to report income and to deduct expenses directly related to honoraria (i.e. weddings, funerals).
  • Churches cannot withhold for social security tax.
  • Churches are not required to do any income tax withholding but they may, pursuant to a W-4 request by clergy, do voluntary income tax withholding for federal and state income taxes.  Voluntary withholding may enable clergy to avoid quarterly estimated tax payments.
  • Accountable expense reimbursement policies may be set-up, which have the advantage of minimizing the economic impact of losing the use of Schedule C. 

Social Security Taxes

The Weber decision applies only to clergy income taxes. Clergy are still considered self-employed for purposes of Social Security and Medicare taxes. The church does not withhold Social Security and Medicare Taxes from a pastor’s salary the way it does for lay employees. Likewise, the church does not have to pay the employers share of Social Security and Medicare taxes for the pastor as it does for lay employees.

Pastors are required to file Schedule SE with their Form 1040. This form is used to calculate the pastor’s self-employment taxes for Social Security and Medicare.

Housing Exclusion Allowance

Pastors are eligible for special treatment of their housing expenses under Section 107 of the Internal Revenue Service Code.

The terms “Housing Allowance” (when the pastor is in his/her own home), “Parsonage Allowance” (when the pastor is in church provided housing), “Rental Allowance”, etc. are used by local churches to describe these payments.

However, the “Housing Exclusion Allowance” described in Section 107 of the IRS Code has a special meaning and can save clergy thousands of dollars in taxes at no additional cost to the church.  

The Code permits clergy to exclude from reported income amounts actually spent by the pastor (not the church) on housing, including pastors living in a church parsonage. (Note: The expenses incurred by the local church in providing a parsonage are not affected by Section 107. It only affects the income tax status of a part of the pastor’s salary.) The exclusion is limited to the lesser of:

  • actual housings expenses,
  • the amount designated as the housing exclusion allowance, or
  • the fair rental value of the property

There are a number of IRS requirements the church and pastor must comply with in order to properly take advantage of this tax break. Both treasurers and clergy are strongly encouraged to review the GCFA Clergy Tax Information package to insure full compliance with the law.

Following are several key points about the Housing Exclusion Allowance:

  • In order to maximize this tax break, the church must set up the housing exclusion allowance before the pastor receives any compensation for the year. (Arrangements cannot be set up retroactively or back dated.)  If the Housing Exclusion Allowance is not established before the pastor receives compensation for the year, the church may establish a Housing Exclusion Allowance during the year. However, only the housing expenses incurred by the pastor after the Housing Exclusion Allowance is established can be excluded from taxable income. Housing Exclusion Allowances can also be amended during the year under the same rules that apply to mid-year adoption of a housing exclusion allowance (i.e. not retroactive or backdated, and housing expenses must be incurred by the pastor after the date of the amendment). The GCFA Clergy Tax Package includes sample forms and resolutions for use by the church.
  • Any housing expenses incurred by the pastor in excess of the amount designated as the Housing Exclusion Allowance are not excludable from taxable income unless the Housing Exclusion Allowance is amended during the year to take into account the higher expenses. (This cannot be done retroactively. The church and pastor must amend the agreement before the pastor incurs any additional expenses.)
  • Any amounts designated as Housing Exclusion Allowance that are not used for housing expenses by the pastor are taxable income to the pastor.
  • The church has two options for dealing with IRS reporting requirements. Under the Church Determination Method, the church works with the pastor at the end of the year to determine the actual amount of the housing exclusion and reports, as appropriate, on the pastors W-2. This method is not recommended. Under the Estimated Exclusion Method, the church reports on the W-2 the salary paid to the pastor without the amount designated as a Housing Exclusion Allowance. Under this method, the Housing Exclusion Allowance is not reported anywhere on the W-2 form. (This is unlike certain other payments reported as memo items in box 13, such as voluntary salary deferrals into the 403 (b) pension plan.) The Treasurer must send a letter, on church letterhead, to the pastor informing them of the amount they were paid for the preceding year as Housing Exclusion Allowance. This letter should be sent at the same time as the pastor is sent the W-2 form. It is then the pastor’s responsibility to settle up with the IRS and state tax authorities. Since this method imposes the least administrative burden on the local church treasurer and the pastor, it is preferred (either method is equally acceptable to IRS).
  • Housing Exclusion Allowance amounts are subject to Social Security and Medicare and must be added to taxable salary by the pastor for calculating taxes due on Schedule SE of Form 1040. Schedule SE is used by clergy to report their self-employment taxes (the equivalent of a lay persons Social Security Tax, except pastors pay at rate of 15.3% instead of 7.65% paid by lay employees).

State and Federal Income Tax Withholding

Clergy are not subject to mandatory Federal and State Income Tax Withholding. However, the pastor may elect to voluntarily have the church withhold these taxes in lieu of filing quarterly personal estimated taxes.

Accountable Reimbursement Plan

Accountable Reimbursement Plans are not unique to clergy. However, these plans are covered in this section because the Weber decision has caused them to be adopted by many churches.

Our Conference’s Equitable Compensation resolution, adopted each year at Annual Conference, provides that each church shall adopt an Accountable Reimbursement Plan. Prior to the Weber decision clergy could deduct all their professional expenses on Schedule C of Form 1040. After that decision, the clergy were subject to limits on deducting these expenses since they were no longer eligible to use Schedule C. This created a disadvantageous tax situation for clergy.

Under an Accountable Reimbursement Plan, the church adopts a policy whereby travel, dues, continuing education and other professional expenses are part of the church operating expense budget. The pastor (and lay employees, if any) submits requests for reimbursement of actual expenses incurred in serving the church along with receipts, invoices, mileage logs, etc. that document the expenses (this is what makes it an “Accountable” plan under IRS rules). Reimbursements to a pastor or lay employee under an “Accountable” plan are not taxable compensation to the recipient and are not reported to the IRS or state tax authorities.

As with Housing Exclusion Allowances, Accountable Reimbursement Plans require compliance with IRS rules and Pastors and Local Church Treasurers are strongly encouraged to review the GCFA Clergy Tax Information package. This document also contains various forms and policies that local churches can use in setting up and administering Accountable Reimbursement Plans.