Tax Planning Rules for Ministers

CPA Journal, The, Sep 2008 by Englebrecht, Ted D, Cameron, Jonathan A

Ministers are individuals who have devoted their lives to teaching, edification, and service to their church and other people. While some ministers may be excellent teachers, pastors, and mentors, many are unfamiliar with the special tax laws applicable to ministers. First, ministers may exclude from federal taxable income amounts designated as housing allowances by their church or organization. Second, ministers may be simultaneously classified as employees for federal taxes and self-employed for Social security and Medicare taxes, a situation known as "dual tax status." Third, ministers are exempt from federal tax withholding but often find it favorable to elect to have taxes withheld. Finally, ministers may request to be exempt from Social Security and Medicare taxes if participating in such programs is contrary to their religious principles.

For many ministerial tax issues, neither the IRS nor Congress provides detailed guidance, and the courts have issued surprising rulings. As a result, much in the area of taxation of ministers remains a question of professional judgment. The following defines the term "minister" for federal tax purposes, discusses in detail those tax aspects specific to ministers, notes several tax snares that ministers should avoid, and details many opportunities for maximizing the tax benefits associated with being a minister.

Definition of a Minister

The five-factor test. According to the IRS, a minister is someone who is "duly ordained, commissioned, or licensed by a religious body constituting a church or church denomination" (Publication 517: Social Security and Other Information for Members of the Clergy and Religious Workers). In 1987, the Tax Court ruled that in order to be classified as a minister, one must perform the duties and functions of a minister within the three types of services described in the Treasury Regulations (Wingo v. Comm'r, 89 TC 922, 1987). These "services performed in the exercise of ministry" include the ministration of sacerdotal functions; the conduct of religious worship; and the control, conduct, and maintenance of religious organizations (including religious boards and societies) under the authority of a religious body constituting a church or denomination [Treasury Regulations section 1.1402(c)-5(b)(2)].

The Tax Court noted that an individual must perform all three services outlined in the regulations, and the individual must also be ordained, commissioned, or licensed, and considered to be a religious leader by his church or denomination to qualify as a minister. This ruling led to the development of the Tax Court's five-factor test for determining ministerial status, shown in Exhibit 1. The court's decision was in conflict with the specific language of the regulations because it required all five conditions to be met. In 1989, the court refined its position (Knight v. Comm'r, 92 TC 199, 1989). The fourth factor (ordained, commissioned, licensed) is a requirement in all cases, but an individual need not fulfill all five factors to qualify as a minister. The remaining four factors must be evaluated on a case-by-case basis.

The IRS no longer issues private letter rulings to answer the question of whether someone qualifies as a minister for federal tax purposes. Because the factors are applied differently in each case and the IRS has not provided definitive guidance, it is often difficult to ascertain if an individual qualifies as a minister. The courts have issued varying rulings, depending on the circumstances.

In Silverman v. Comm'r (57 TC 727, 1972), the Tax Court held that a Jewish cantor qualified as a minister, although not officially ordained. Since formal ordination is not required for commissioning in the Jewish faith, and the cantor performed religious duties within his congregation, the cantor was recognized as a minister for tax purposes. However, in Lawrence v. Comm'r (50 TC 494, 1968), the Tax Court ruled against the taxpayer, a minister of education in a Baptist church. Although he had a master's degree from a Baptist seminary, he was not an ordained minister and did not administer sacraments or preach at worship services and, thus, was denied minister status.

Special Tax Rules for Ministers

Tax benefits versus tax immunity. While ministers enjoy many tax benefits, they are not exempt from paying federal income taxes. The Supreme Court has ruled that requiring ministers to pay income taxes does not infringe upon their religious freedom guaranteed under the First Amendment (Murdoch v. Pennsylvania, 319 US 105, 1943). Arguments by ministers in attempts to avoid income taxes are dismissed as frivolous by the IRS, and substantial penalties, back taxes, and interest may result.

Parsonage exclusion. Arguably the most significant tax benefit available to clergy is the ability to receive payments for living expenses tax-free. This is known as a "parsonage" or housing allowance. IRC section 107 states that amounts received by a minister for a parsonage or housing allowance are exempt from federal income tax. The concept of parsonage began about 100 years ago, when congregations provided housing as an incentive for clergy to come to their church (see "Clergy Present Special Opportunities and Challenges," by Laurence Dresner, Journal of Practical Estate Planning, June-July 2006, pp. 53-60). Because many congregations are only able to pay their ministers a low or modest salary, parsonage is a tool to provide much-needed compensation tax-free ("Tax Planning for Servants of God," by Frances E. McNair, Edward E. Milam, and Deborah L. Seifert, Journal of Accountancy, October 2004, pp. 65-69).