If you are a minister, you are subject to some tricky income tax and Social Security tax rules. We'll point out:How your income is taxed; how to claim an exemption from self-employment tax; how to get a tax-free parsonage allowance; limits on deductions if you get a tax-free allowance; where to report your income; and deductions that you can easily overlook.
How a minister's income is taxed
If you are a minister of a church, your earnings for the services you perform in your capacity as a minister are subject to self-employment tax unless you have requested and received an exemption. (We'll cover the exemption process next.) This includes any salary that is paid to you as an employee of the church (even though reported on Form W-2, the church does not withhold Social Security or Medicare taxes), as well as offerings and fees such as those for performing marriages, funerals and baptisms.
To be treated as a minister, you must be duly ordained, commissioned or licensed by a church or church denomination and have the authority to conduct religious worship, perform sacerdotal functions and administer ordinances or sacraments. The same goes if you are a Christian Science practitioner or reader. Your earnings from services you performed are generally subject to self-employment tax, with one significant exception we'll discuss next.
Exemption for the self-employment tax for certain ministers
If you are conscientiously opposed to public insurance because of individual religious considerations, or you are opposed because of the principles of the religious denomination you belong to, you can claim an exemption from the self-employment tax by filing Form 4361 with the IRS. If the exemption is granted, you do not pay Social Security or Medicare taxes on your earnings. Of course, neither do you get credit toward Social Security or Medicare benefits in retirement. You must file Form 4361 by the due date of your tax return for the second tax year in which you earned at least $400 of self-employment earnings as a minister.
Once you claim the exemption, you cannot revoke the election. Although the income you earn is not subject to self-employment tax if the election is granted, you can use the income as the basis for contributions to a qualified retirement plan, such as a Keogh plan or individual 401(k).
Ministers can exclude from their income a rental allowance or the fair rental value of a parsonage that is provided to them as pay for their services. This exemption applies only for income tax purposes. The exclusion does not apply to self-employment taxes.
For a payment to qualify for the income tax exclusion, the church must officially designate it as a housing or rental allowance before it is actually paid. A definite amount must be designated. The amount of the allowance cannot be determined at a later date.
If you receive a rental allowance, you can exclude it from your gross income if the amount is used to provide or rent a home, and it does not constitute excessive pay for your services or exceed the fair rental value of the home, including furnishings, plus the cost of utilities.
If the church provides a residence, you can exclude from gross income the fair rental value of the house, including utilities, furnished to you as part of your earnings. But just like a rental allowance, the exclusion cannot be more than the reasonable pay for your services. If you pay for the utilities, you can exclude any allowance designated for utility costs, up to your actual cost.
Example: Rev. Joan Carlton is a full-time minister. The church allows her to use a parsonage that has an annual fair rental value of $24,000. The church pays her an annual salary of $60,000, of which $7,500 is designated for utility costs. Her actual utility costs during the year were $7,000. For income tax purposes, Rev. Carlton excludes $31,000 from gross income ($24,000 fair rental value of the house plus $7,000 from the allowance for utility costs).
She will report on her 1040 as income $53,000 ($52,500 net salary plus the $500 of unused utility allowance). However, her income for self-employment tax purposes is $84,000 ($60,000 gross salary plus the $24,000 fair rental value of the home).
Limitation on deductions for ministers receiving parsonage allowances
The downside to receiving a tax-free rental or parsonage allowance is that the tax code denies a tax deduction for part of the expenses of operating your ministry. The nondeductible amount is the portion of your expenses that is allocated to your tax-free rental or parsonage allowance. But this rule does not limit your deductions for home mortgage interest or real estate taxes on your home.
- Example: Rev. John Schmidt received $50,000 in ministerial earnings consisting of a $28,000 salary for ministerial services, $2,000 for weddings and baptisms, and a $20,000 tax-free parsonage allowance. He incurred $4,000 of unreimbursed expenses connected with his ministerial earnings. $3,500 of the $4,000 is related to his ministerial salary, and $500 is related to the weddings and baptisms he performed as a self-employed person.The nondeductible portion of expenses related to Rev. Schmidt's ministerial salary is $1,400, figured by dividing the $20,000 tax-free allowance by the $50,000 of total earnings and multiplying that fraction by $3,500.The nondeductible portion of expenses related to Rev. Schmidt's wedding and baptism income is $200, calculated by dividing the $20,000 tax-free allowance by the $50,000 of total earnings and multiplying that fraction by $500.
If you are affected by this deduction cutback, you'll have to attach a detailed statement to your tax return. TurboTax will walk you through all of the steps necessary to do this.
The statement must contain all of the following:
- A list of each item of taxable ministerial income by source (such as wages, salary, weddings, baptisms, etc.) plus the amount.
- A list of each item of tax-free ministerial income by source (parsonage allowance) plus the amount.
- A list of each item of otherwise deductible ministerial expenses plus the amount.
- How you figured the nondeductible part of your otherwise deductible expenses.
- A statement that the other deductions claimed on your tax return are not allocable to your tax-free income.
Where to report your income
You report your income in different places on your return depending on whether it is salary (W-2) income or self-employment income.
- Income that you receive for offerings and fees—Report this as self-employment income on Form 1040, Schedule C or Schedule C-EZ, Profit or Loss from Business.
- Salary income—Report this income on Form 1040.
- Expenses related to your salary income—For tax years prior to 2018, report the expenses as miscellaneous deductions subject to the 2% limit of adjusted gross income on Form 1040, Schedule A. As we noted earlier, the expenses must be prorated between your W-2 income and your housing allowance, making a portion of them nondeductible. Beginning in 2018, unreimbursed employee expenses are no longer deductible for federal taxes but some states, such as California, still allow this deduction for state income tax.
- Expenses related to your self-employment income—Deduct these expenses on Schedule C or Schedule C-EZ. Examples of these costs include travel, office expenses, subscriptions, books and computers.
Easy-to-miss deductions for ministers
Ministers should make sure they don't fail to claim two key tax write-offs:
- The self-employment tax deduction—You can deduct half of your self-employment tax on Form 1040 as an adjustment to income.
- Health insurance costs—You can deduct the amount you paid for medical and dental insurance and qualified long-term care insurance for you, your spouse and your dependents. The deduction does not reduce your net earnings for self-employment tax purposes, and thus does not reduce your self-employment tax liability.
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