Tax considerations for ministers.

• Author: Campbell, Alan D.

EXECUTIVE SUMMARY

* Ministers (including their functional equivalent in any religion) may exclude from gross income a cash housing allowance paid or the rental value of a home provided in-kind. Exclusion of the allowance is limited to the amount actually used to rent or provide a home and to the fair rental value of the home, furnishings, and appurtenances, plus the cost of utilities and other qualifying expenses. It may not exceed the minister's total compensation.

* The housing allowance exclusion does not reduce itemized deductions for mortgage interest and real estate taxes, but any employee business expenses claimable as miscellaneous itemized deductions must first be reduced by the percentage the excluded housing allowance bears to gross income calculated without regard to the exclusion.

* Ministers generally are exempt from employee withholding on compensation paid by their church but must pay self-employment tax unless they qualify for an exemption. Self-employment income for this purpose includes the housing allowance. Any unreimbursed employee expenses may be deducted in full from self-employment income.

* "Love offerings" and other payments by a church congregation to active ministers are generally taxable compensation rather than tax-free gifts. However, when these types of payments are made to a retiring or departing minister, they may be considered gifts instead of income.

PREVIEW

* Ministers paid a housing allowance or provided housing by a church as part of their compensation generally may exclude its value from gross income for federal income tax purposes, but practitioners must know the nuances of the rules.

* While generally considered to be employees of their church, ministers are usually subject to self-employment tax unless they apply for and are granted an exemption.

* The exclusion from income for housing and housing allowances, along with other special tax rules for ministers, offers valuable tax planning opportunities.

The tax treatment of ministers and churches has been in the news in recent years. Much of the media attention has resulted from lawsuits filed by the Freedom From Religion Foundation. The organization has challenged the constitutionality of the tax-free housing allowance for ministers and electioneering activities of ministers in their official capacities.

Ministers work for churches or other religious organizations, which are usually tax-exempt organizations under Sec. 501(c)(3). This tax-exempt status allows contributions of cash or property to the church to be tax-deductible under Sec. 170.

Unlike in the case of other organizations that wish to be tax exempt, Sec. 508(c)(1)(A) provides that churches, integrated auxiliaries of churches, and conventions or associations of churches do not have to apply for tax-exempt status using Form 1023, Application for Recognition of Exemption Under Section 501(c)(3) of the Internal Revenue Code. A church's tax-exempt status is automatic as long as it operates exclusively for purposes specified in Sec. 501(c)(3), which include religious, charitable, and educational purposes.

Prohibitions Against Private Inurement and Electioneering

Sec. 501(c)(3) prohibits any individual from receiving any private inurement from a church or other tax-exempt charity. Thus, a minister may receive payments from a church only for reasonable compensation for services rendered and reimbursements for expenses incurred on behalf of the church.

Sec. 501(c)(3) also prohibits the church from having as a substantial part of its activities the carrying on of propaganda or attempting to influence legislation. Sec. 501(c)(3) also prohibits the church from participating in any campaign for any candidate for public office or opposing such a candidate.

Some ministers believe the prohibitions on attempting to influence legislation and supporting or opposing candidates for public office are unconstitutional infringements on their rights of free speech and free exercise of religion under the First Amendment. Such ministers believe it is their duty to support candidates whose views are congruent with their religious views and oppose candidates whose views conflict with their religious views.

An organization called Alliance Defending Freedom has organized an annual event called "Pulpit Freedom Sunday," on which ministers are invited to preach a sermon "addressing" an upcoming election, including, if they wish, applying "Scripture to the stated positions of candidates." The organization states this could cause the IRS to impose an excise tax or challenge a church's tax-exempt status under Sec. 501(c)(3). Then the church could challenge the IRS in court on the constitutionality of the prohibitions on participating in elections. (1)

Although the Alliance reports that the IRS "has not responded" to the tactic, engaging in such a protest activity could place the tax-exempt status of the church at risk. If a church loses its tax-exempt status, contributions to the church would no longer be tax-deductible.

In Freedom From Religion Foundation, (2) the plaintiff organization wanted the court to enjoin the IRS from failing to enforce the prohibitions in Sec. 501(c)(3) regarding supporting or opposing candidates for public office and to require the appointment of a high-level official in the IRS to enforce these provisions. The parties reached an agreement and made a joint motion to dismiss the case without prejudice, which the district court granted on July 29, 2014. The agreement requires the IRS to monitor churches for electioneering activities. However, the IRS may conduct inquiries into a church's tax-exempt status only as allowed by Sec. 7611 and Internal Revenue Manual (IRM) Section 4.76.7 (8/20/10).

Other Tax Considerations Unique to Ministers

In addition to complying with the requirements of Sec. 501(c)(3), ministers have other tax considerations unique to them. These include the tax-free housing allowance, also known as the "parsonage" allowance, and exemption from income tax withholding. This article explains the requirements to be a bona fide "minister of the gospel" to qualify for the tax-free housing allowance and then discusses the exclusion for the housing allowance in depth, including its effects on the deductions for mortgage interest, real estate taxes, and business expenses. The discussion reviews some recent court decisions concerning the tax-free housing allowance.

This article also discusses how ministers are generally employees for income tax purposes but pay self-employment tax rather than having taxes withheld. The article examines whether offerings a minister receives directly from members of the congregation on special occasions are tax-free gifts or taxable compensation. It then concludes with some tax planning tips for ministers.

Who Is a Minister?

For purposes of the exclusion for the housing allowance, a minister is an individual who performs ministerial services such as sacerdotal functions, conducting religious worship, and/or controlling or maintaining a religious organization as a function of a church that exists to carry out the religious beliefs of a particular faith. (3) In addition, the governing authority of the particular faith must have licensed, commissioned, or ordained the individual according to the requirements of the particular faith. The terms "minister" and "of the gospel" are not specific to any particular religion. Instead, the courts and IRS use them broadly to encompass the leader of worship in any religion.

In Salkov, (4) the Tax Court defined a minister as "one who is authorized to administer the sacraments, preach, and conduct services of worship." The court held that Congress intended for the exclusion for the housing allowance to apply to both Christian ministers and individuals who are the equivalent of Christian ministers in other religions.

Exclusion for Housing Provided by a Church

A minister may exclude from gross income the rental value of a home a church provides in kind or a cash housing allowance received from the church. (5) To qualify for the exclusion, the minister must receive the use of the house or cash housing allowance as a part of the minister's compensation. A minister may exclude a cash housing allowance only to the extent the minister uses it to rent or provide a home. Another limit on the exclusion for the housing allowance is the sum of the fair rental value of the home, furniture, and appurtenances such as a garage, plus the cost of utilities. (6)

Two or More Homes

If a minister has two homes and receives a housing allowance for each home, may the minister exclude the housing allowance received for both homes? In Driscoll, (7) the Tax Court said yes. On appeal, the Eleventh Circuit reversed this decision. Driscoll petitioned the Supreme Court to hear the case, but it refused to do so. (8)

The Tax Court follows the Golsen (9) rule, under which, if a similar case would have appeal rights to the Eleventh Circuit, the Tax Court would follow the decision of the Eleventh Circuit. Thus, if a minister lives under the jurisdiction of the Eleventh Circuit (Alabama, Georgia, and Florida), the minister may exclude a housing allowance for one home only. If a minister lives in a different circuit, the minister could file a petition in the Tax Court if the IRS denied the exclusion for two or more homes. Whether the Tax Court will follow its own precedent in future cases for which the right of appeal is to a different circuit or follow the decision of the Eleventh Circuit in all circuits remains to be seen.

Is the Tax-Free Housing Allowance Constitutional?

Is the exclusion for a minister's housing allowance constitutional? In Freedom From Religion Foundation, (10) the District Court for the Western District of Wisconsin said no. The court ruled the exclusion for a cash housing allowance is unconstitutional because it violates the Establishment Clause of the First Amendment. The court did not render...