Your income tax forms for 2000 have just arrived in the mail, and already you're about to miss your best opportunity to save money next year. You probably have many questions: should I call an accountant or employ a pencil and a large eraser? Can I deduct my home office? Should I claim depreciation on my ministry-related computer or take the first-year write-off instead? Those are good questions, and the answer is—it depends. But your largest tax savings potential for 2000 has nothing to do with how your return is prepared. After-the-fact planning has little impact on taxes once income has been received, a housing allowance has been designated, and expenses have been paid. As you pull together your W-2s, itemized deduction data, receipts for unreimbursed expenses, notations of your honoraria and fee income, you need to consider the best approach for the tax return you will file in April 2002. A representative or a small committee representing the lay leadership should meet annually with the pastor to discuss pay expectations, review past pay patterns, and examine the tax consequences of compensation components before the compensation package is finalized. If you haven't done that for 2001, now is the time.
Employee or self-employed?
This is a confusing area. Ministers are virtually all considered to be employees for income tax purposes. (The church should annually provide Form W-2, rather than Form 1099). On the other hand, ministers are considered self-employed for social security purposes. Based on the tax rulings of the last decade, the IRS is well-armed with ammunition to reclassify any minister who includes all ministerial income on Schedule C. And this often results in tax, penalty, and interest assessed to the minister. And ministers who file as self-employed for income tax purposes generally understate their income. They often fail to realize that many fringe benefits, such as health insurance, are fully taxable to them when filing as self-employed instead of as an employee for income tax purposes. Ministers pay self-employment Social Security tax calculated on Schedule SE. (FICA tax should not be withheld from a minister's pay and matched by the church—this only applies to laypersons).
Make the most of your housing allowance
The church's proper handling of the housing allowance is a fundamental part of stewarding the minister's compensation.1. The housing allowance designation. A formal designation is important. Formalizing the housing allowance is initiated by resolution of the top church governing body and then recorded in written minutes. Adopting the housing allowance before compensation is paid is a must. A housing allowance cannot be adopted retroactively. The housing allowance should be adopted annually by the church unless the resolution is "evergreen" and will remain in force until it is superceded by a subsequent resolution.2. Allowances and church-provided housing. Even when a church provides housing for a minister, the designation of a modest housing allowance is generally advantageous. For example, most ministers living in church-provided housing incur expenses for furnishings, local telephone service, and other items that can be included under a housing allowance.3. Setting the amount. Most churches ask the minister to suggest an appropriate amount for the housing allowance and then they formalize the designation. A church can designate as much as 100 percent of the minister's cash compensation as a housing allowance, which may be appropriate if the minister's actual housing expenses are anticipated to equal the cash salary, but that would be the exception rather than the rule. For example: a minister's cash compensation, before considering fringe benefits, is $50,000. Because of the purchase of a new home and the outlay for a down payment, actual housing costs are anticipated to be $60,000 for the year. Designating the entire $50,000 cash salary as a housing allowance may be appropriate in this instance.
Use the right retirement plan
Churches are increasingly stepping up to their responsibility to provide adequate retirement dollars for ministers. But of all the compensation planning elements, this one may be the most confusing. What pastor really wants to understand the difference between a 403(b) and a 401(k)? A traditional IRA or a Roth IRA? Then, consider the complexity of the limits that apply to the various kinds of retirement plans. If your church is making modest payments to a tax-sheltered annuity plan, also known as a 403(b), the annual limits may not come into play. "However, when churches are behind in caring for a pastor's retirement and try to catch-up by making large contributions to a retirement plan, they can easily exceed the legal limits," says attorney John S. Butler of Capin Crouse LLP. To defer compensation beyond the dollar limits for a tax-sheltered annuity plan, a church may consider a "rabbi trust." An independent trustee invests the amounts that have been deferred. The assets may still be used to pay creditors of the church (in a bankruptcy, for example), but cannot be reclaimed by the church for its operations. When considering these and other ministerial retirement planning options, it is often wise to obtain professional guidance.
Putting your insurance in good hands
Paying for a minister's health insurance coverage is one of the most fundamental financial obligations of a church. The largest churches often self-insure, but this is not an option for most churches because the employee pool is too small. Health insurance premiums covering the minister and family can be paid directly or reimbursed to the minister tax-free. According to Don Walter, director of Pensions and Benefits USA at the Church of the Nazarene International Headquarters in Kansas City, "Churches should generally avoid 'non-insurance' or questionable medical insurance solutions." The "newsletter" or assessment approach is a form of "non-insurance." These plans claim to not be insurance in order to escape the wrath of State Insurance Commissioners. But since they are not insurance, payment by a church to these plans (or to reimburse the minister's payments to these plans) is a fully taxable benefit. Questionable solutions also include plans designed to serve labor unions. Large churches often establish cafeteria plans that not only cover health insurance but also group term-life insurance up to $50,000 and dependent care payments. But even the smallest church can save tax dollars for its minister by setting up a medical expense reimbursement plan. These plans should be written to provide the necessary guidelines for the church treasurer. Most of these plans are funded by a reduction of the minister's salary. The benefit is to convert medical expenses—typically representing deductions that are lost as itemized deductions because of the medical expense floor—to reimbursements that are tax-free for income and social security tax purposes.
Your best tax savings
Reimbursement for professional expenses almost seems too simple. A dollar reimbursed is worth a dollar. But a dollar deducted is only worth a fraction of a dollar (based on your tax rate). When speaking to a group of ministers, I typically ask how many have all of their expenses reimbursed by the church. Usually, only one or two hands will be raised. This is a tragedy. Consistent with the position that the IRS takes on ministers filing as employees for income tax purposes, unreimbursed expenses related to a minister's work can only be deducted on Schedule A as miscellaneous itemized deductions. Ministers who live in church-provided housing generally do not itemize their deductions, so deducting unreimbursed expenses there will often have no or little tax benefit. And unreimbursed expenses have limited value even for ministers who regularly itemize their deductions. The 2 percent of adjusted income floor on miscellaneous itemized deductions, the 50 percent limitation on meals and entertainment, and the allocation of expenses based on the ratio of the housing allowance exclusion to total ministerial income severely limit the value of unreimbursed expenses. Full reimbursement of a minister's church-related expenses (including reimbursement of church-related miles at the maximum IRS rate, if the mileage method is used) should be a top priority. As you're sifting through that shoebox of receipts and check stubs, remember that your best tax shelter is pre-planning. Read up on the subject and ask the finance committee to review your compensation package. That way, for 2001, you can render unto Caesar only what's due him—nothing more.
Dan Busby, CPA, is vice president of the Evangelical Council for Financial Accountability (ECFA). His book, The Minister's Tax & Financial Guide (Zondervan), has been published annually since 1990.
Copyright © 2001 by the author or Christianity Today/Leadership Journal.Click here for reprint information on Leadership Journal.
