How likely are you to be audited?
Ministers who report their income taxes as employees, earn less than $100,000 per year, do not have excessive itemized deductions, and do not claim any “audit triggers,” have an audit risk of about 1 percent. This is close to the overall audit risk for all taxpayers. There are about 500,000 ministers in the United States, meaning that 5,000 of them could be audited each year.
Of course, some regions have higher audit risks. The audit rate is highest in the IRS Western region (Alaska, California, Hawaii, Idaho, Nevada, Oregon, and Washington).
Since moving is not much of an option, here are eight tips for all ministers to reduce your risk of being audited–or lower your penalties if you are.
1. Report income taxes as an employee.
The Tax Court recently ruled that a United Methodist minister in North Carolina could not report his church compensation as a self-employed professional for federal income tax purposes. The Court concluded that the minister was an employee for income tax purposes.
The evidence is mounting–taxpayers who report their income taxes as self-employed workers face a far higher audit risk than do those who file as church employees. According to the most recent IRS data, the chances of a self-employed taxpayer being audited are as much as 400 percent greater than for an employee with the same income. The lesson is clear–if you report your income taxes as a self-employed person, you are asking for IRS scrutiny.
Why are self-employed taxpayers a target? Government statistics demonstrate that the “voluntary tax compliance rate” of self-employed persons is a dismal 13 percent compared with a 99 percent rate for employees covered by mandatory tax withholding.
2. Pay self-employment (social security) tax on all your salary–including housing allowance.
Many ministers overlook the fact that the housing allowance is an exclusion for income tax purposes only. It is not available in computing your self-employment (social security) tax. Claiming the housing allowance in computing self-employment taxes will lead to a substantial understatement of tax. If the understatement exceeds the greater of (1) 10 percent of the actual income taxes that should have been paid, or (2) $5,000, then you will owe a special “substantial understatement” penalty.
The penalty is computed by multiplying 20 percent times the portion of an underpayment of income taxes that is due to the substantial understatement. Further, the period of time during which the IRS can audit you for this item may be increased from three to six years.
3. Follow the Deason Rule.
According to the Deason Rule, named after a 1964 Tax Court ruling, ministers must reduce their business expense deductions by the percentage of their total income that consists of a tax-exempt housing allowance.
Let’s say a minister has a total compensation of $40,000, of which $10,000 is a housing allowance. Any business expense deduction, then, must be reduced by 25 percent (since $10,000 is 25 percent of $40,000). If this pastor had $4,000 of business expenses, his or her business expense deduction would be reduced from $4,000 to $3,000.
While the IRS did not enforce this rule for many years, it is doing so now. The current edition of IRS Publication 517 contains helpful guidance on how to reduce your business expenses under this rule. (Note: this rule can be avoided completely if a church reimburses business expenses under an accountable arrangement.)
4. Get the church to reimburse your expenses.
Churches that reimburse business expenses with an accountable reimbursement arrangement reduce a minister’s audit risk. Why? Because the minister reports business expenses to the church rather than to the IRS. Under this arrangement, the church reimburses those business expenses that are properly substantiated. The church’s reimbursements are not reported as taxable income, and the minister’s business expenses are not reported anywhere on the Form 1040 because the expenses were fully reimbursed.
Since business expense deductions are a major focus of the IRS, you will be reducing your audit risk significantly by eliminating them from your tax return.
(Caution: Personal expenses cannot be reimbursed under such an arrangement. Nor can the cost of commuting between your home and the church.)
5. Watch your itemized deductions.
Some taxpayers have a much higher risk of being audited because their itemized deductions exceed ranges established by the IRS. While the IRS does not publish its audit criteria, it does publish the average itemized deductions claimed by taxpayers based on the amount of their income. This information is helpful in comparing the size of your deductions with the average amounts claimed. The most recent data (for 1992 returns) is reproduced on page 100.
6. Know the “audit triggers.”
Several deductions increase your audit risk: home office expenses, entertainment expenses, and education expenses. If you claim a deduction for any of these, be sure you satisfy all of the legal requirements. The rest of your tax return may be examined too, so be sure you are not taking unreasonable positions with respect to any other item.
IRS data reveal what most would expect–your audit risk increases with your income. The more income you earn, the greater your audit risk. Higher-income ministers should be more cautious in preparing their tax returns.
7. Keep adequate receipts.
If you claim a deduction for unreimbursed business expenses, or expenses reimbursed under a nonaccountable arrangement, you must have adequate receipts to substantiate most deductions. In general this means that you have documentary evidence to prove the amount, date, place, and business purpose of each expense. Receipts are required for expenses of $25 or more.
Be sure you have receipts to substantiate your housing expenses. The amount of your salary designated by your church as a housing allowance is not reported as taxable income (for income tax reporting purposes)–but only if the allowance is used for housing expenses. This means that if you are audited, you may be asked to prove that you had housing expenses equal to or exceeding your housing allowance.
If your housing expenses do not equal or exceed your housing allowance, this can lead to substantial additional taxes with interest and possibly penalties. You may have to report additional income on your tax return, assuming that the church reduced the income reported on your W-2 form by the full amount of the housing allowance.
8. Report all income.
Many ministers fail to report all items of income. Common examples of overlooked items include Christmas and other special occasion “gifts” paid to the minister by the church, personal use of a church-owned vehicle, and no-interest or low-interest loans. Failure to report these items can lead to significant additional taxes in the event of an audit.
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Richard R. Hammar is an attorney and CPA, and author of “Church Law & Tax Report.”
Copyright (c) 1995 Christianity Today, Inc./LEADERSHIP Journal
Copyright © 1995 by the author or Christianity Today/Leadership Journal. Click here for reprint information on Leadership Journal.
