UPDATED JANUARY 2025
MINISTRY AND CLERGY TAX ISSUES
This is a complex topic, requiring those involved to intentionally educate themselves and seek out information from the IRS regulations and other reliable sources of law.
Below is a detailed summary of special income tax issues applicable to clergy/ministers. All information provided is intended for educational purposes and is not legal advice. Tax laws are constantly changing. The reader must first educate themselves, and then seek competent guidance as necessary and be aware of applicable legislative, administrative, and judicial action that may have occurred since preparation of this document. See Resources and helpful links listed at the bottom of this document.
When is an individual considered a minister for tax purposes?
Whether the services of a duly ordained, licensed, or commissioned clergy person are classified as in the “exercise of ministry” for federal tax purposes determines if tax rules unique to clergy are applicable.
For services other than as an employee of a theological seminary or church-controlled organization, in order to be considered in the exercise of ministry the services must involve either:
The ministration of sacerdotal (priestly) functions (communion, baptism, weddings, funerals, etc.), or
The conduct of religious worship
The following should also be considered:
The determination of what constitutes the performance of “sacerdotal functions” and the conduct of religious worship depends on the tenets and practices of the individual’s church. Treas. Reg. § 1.1402(c)-5(b)(2)(i).
A minister who is performing the conduct of worship and ministration of sacerdotal functions is performing service in the exercise of his/her ministry, whether or not these services are performed for a religious organization. Treas. Reg. § 1.1402(c)-5(b)(2)(iii).
The service of a chaplain in the Armed Forces is considered to be those of a commissioned officer and not in the exercise of his or her ministry. Treas. Reg. § 1.107-1(a)
What special tax issues are applicable to compensation paid for services in ministry?
Except for ministers employed by units of government and military, compensation is not subject to income tax withholding, although ministers often elect to have income tax withheld. Tax withholding is strongly recommended, as the IRS sees federal withholding tax to have been “paid in a timely manner”, whereas Estimated Tax payments are tagged on the date received.
With the exception of clergy employed by government agencies as discussed later, ministers are considered self-employed for Social Security tax purposes. Unless granted exemption from Social Security coverage, ministers pay Social Security tax under the Self-Employment Contributions Act (SECA).
A minister is eligible to exclude from gross income the rental value of an employer provided dwelling or the payment of a cash housing allowance, to the extent used to provide a home. Such a housing exclusion has no effect upon the amount of income subject to Social Security taxes.
Are ministers employees or self-employed?
Most ministers have a dual tax status for services performed in the exercise of ministry. That is, they are employees for income tax purposes under common law (federal and state income tax), but are treated as self-employed by statute for purposes of Social Security coverage/Self Employment (SE) tax. The proper classification of a minister as an employee or independent contractor for income tax purposes is determined on a facts and circumstances basis in the same manner as secular employees, using the criteria outlined in IRS Publication 15-A, Employer’s Supplemental Tax Guide.
Should I consider exempting (“Opting Out”) from social security (S/E tax) for ministerial earnings, through Form 4361:
This is a legal and ethical option for the minister. A minister who wishes to be exempt from social security/Medicare tax (for ministry income only) must file a Form 4361 with the IRS for approval. Before your application can be approved, the IRS must verify that you are aware of the grounds for exemption and that you want the exemption on that basis. The grounds for opting out are not are based on opposition to the acceptance of public insurance with respect to services performed as a minister. Note that opting out only applies to ministerial earnings. A minister is not being inconsistent in accepting SS or Medicare benefits from non-ministerial earnings.
Note: A pastor pays the self-employment tax on theTOTAL of his wages INCLUDING the housing allowance. In the event that he lives in a church owned parsonage, he pays his self-employment tax on the total of his wages including the parsonage value and church paid utilities. Every dollar of housing allowance that is actually spent, is not included in income for federal INCOME tax purposes (but not SE). This is reconciled through the tax return.
When your completed Form 4361 is received, the IRS will evaluate eligibility. It is extremely important to complete all steps (in triplicate) and provide ALL information requested, or you will not be exempt. Once the IRS approves it, you will receive a copy marked approved.
But is it really ethical to opt out? Yes. The current laws requiring ministers to pay SE tax make it near impossible to maintain a living for a family, on the typical minister’s salary. My spouse and I opted out decades ago because we could not afford to the pay the SE tax, provide for our children – or buy toilet paper.
Opting out is currently irrevocable. Once out, the minister cannot revoke the election.
The approved Form 4361 is an important document. And the minister should keep a copy. In addition, a copy of the approved form should be provided to any employer from which the minister receives a salary. A copy should also be given to the tax return preparer for his/her records.
But, should I really opt out? This is a personal decision. There are strong opinions on this. In the Christian community…I’d say it’s about 50/50 “yes or no”.
Some reasons to opt out:
Financial – have the discipline to put the 15.3% FICA (or even 5 to 10%) into a retirement account. You will be SO happy and better off. Most church’s DO contribute to your 403(b). Match their contribution if possible. Do $25 a month until you can do more.
Knowledge - The first and most important thing you need to have is knowledge of exactly what Social Security means. For the purposes of ministers applying to become exempt from self-employment tax, the definition of Social Security according to IRS Form 4361 is as follows:
Public insurance that makes payments to you in the event of death, disability, old age, or retirement
Payments toward the cost of, or to provide services for, medical care.
In reality the self-employment tax you pay covers retirement benefits, Medicare, and Medicaid. Many do not know that Social Security and Medicaid are all part of one program. Remember this. It is VERY important to know that you should keep track of your social security units/quarters. A person needs 40 quarters of credit with the SSA in order to be eligible for Medicare.
Conscientious Objection - Part of applying to opt-out with Form 4361 requires you to sign a confusing statement. If you dig deep, you’ll realize that you qualify to opt-out. Below is the statement from the form: “I certify that I am conscientiously opposed to, or because of my religious principles I am opposed to, the acceptance (for services I perform as a minister, member of a religious order not under a vow of poverty, or Christian Science practitioner) of any public insurance that makes payments in the event of death, disability, old age, or retirement; or that makes payments toward the cost of, or provides services for, medical care. (Public insurance includes insurance systems established by the Social Security Act.)”
This statement can be broken down by looking at the words in bold. For clarification purposes, I have strung them together:
“I certify that I am conscientiously opposed to the acceptance of any public insurance that makes payments toward the cost of medical care.”
Religious principles – Stewardship/Frugality/Saving for your children/heirs
A rarely noticed provision in the statement from Form 4361 is that you are opposed for religious principals. A common religious principal is simply the fact that some believe putting money into the Social Security system is bad stewardship (parable of the talent) of what God has entrusted to them. Others say that since Social Security benefits are not inheritable, it runs against Proverbs 13:22, which says, "A good person leaves an inheritance for his children's children.”
Important:
The IRS law says that a minister, once ordained, faces a timing issue. The law states that your 4361 application must be signed and submitted to the IRS on or before the due date of your 2nd personal tax return where you earned at least $400.00 in ministry as a minister.
Reasons NOT to opt out:
Reason 1: You Have to be Conscientiously Opposed (See above)
Reason 3: Social Security Protects You from Outliving Your Savings (Might be true without good planning/disciple) Disciplined retirement savings is crucial.
Reason 4: Social Security Provides a Disability Component (So does disability insurance)
Reason 5: Increased Medicare Costs (Not if you make sure you’re vested in social security from other earnings)
HOUSING ALLOWANCE
What is the IRS legal authority for establishing a housing allowance?
Internal Revenue Code § 107 authorizes an exclusion from gross income, the rental value of an church/employer provided home (parsonage) or for the payment of an allowance to a minister to provide a home. A housing allowance is available to qualified employees of federal, state, and local government. Treas. Reg. § 1.107-1(a).
Is a housing allowance mandatory?
In general, whether to treat qualifying services of a minister as in the exercise of ministry and to designate a housing allowance is the employer’s decision.
Certain states mandate this classification for their state-employed chaplains through statutory provisions, or authorize it through administrative agency action. Other states do not designate a housing allowance for state-employed clergy.
In 1972, the IRS ruled that chaplains employed by the federal government are not eligible to exclude a housing allowance because there is no statutory authority for any federal agency to make the required advance designation. The IRS affirmed this position again in 2002. It appears that legislative action would be required to extend housing allowance availability to chaplains employed by the federal government.
How is a housing allowance designated and implemented?
The tax regulations require that the housing allowance be designated pursuant to official action taken in advance of such payment by the employing church or other qualified organization. Treas. Reg. § 1.107-1(b).
There is no prescribed form or wording for the designation (Housing Allowance Request), but it should include all of the following elements:
Date, to establish that designation occurred in advance of payment
Name of minister
Designation of a dollar amount as housing allowance under Section 107 of the Internal Revenue Code
Period for which the designation is to be effective
Name, title, and signature of designating official
A breakdown of expected expenses provided by the minister is NOT required – although a list of possible expense categories can be helpful in determining the allowance amount.
It is permissible to make a “perpetual” designation, i.e. stating that the designation applies to all future compensation until changed or revoked, so that it is not necessary to provide another designation for future periods unless there is a change. IRS Publication 517 states that a definite amount must be designated.
How much may be designated as a housing allowance?
The maximum amount that may be designated as a housing allowance is the reasonable value of services performed by the minister (the minister’s salary). Thus, if compensation is not excessive in relation to the value of services performed, it is permissible to designate the entire amount of compensation as a housing allowance (100% of salary). For the sake of the tax preparer and the financial data transferring to a W2, it is recommended that the minister not designate 100% of their salary. A “zero $” entry on the wage line (Box 1) of the W2, causes confusion – and does not work with current tax software. Box 1 should include at least a $1 amount.
The minister needs to be intentional with planning and requesting the designated amount. A common practice is to designate an amount that is above the portion of salary typically used for the costs of providing a home, in order to lessen the risk of the employee losing any tax benefit as a result of the employer under-designating a housing allowance.
What happens to the housing allowance designation? (What happens with payroll)
The employer should provide a duly authorized copy of the housing allowance designation to the minister employee and keep a copy in the personnel file. The designation is not filed with the IRS by the employer, nor should it be filed with the employee’s tax return. Only in the event of an audit might it be necessary to provide a copy to the IRS. The employer should ensure that the Housing Allowance designation amount is included in Box 14 of the W2.
How is a housing allowance reported on an employee’s pay stub?
There is no prescribed format for reporting a housing allowance on an employee’s pay statement. However, it is good practice to show the housing allowance as a separate element of total compensation. This facilitates verification of correct payment and proper withholding of any applicable taxes.
How is a housing allowance reported on IRS Form W-2, Employee Wage Statement?
The incorrect reporting of a housing allowance as the result of an improperly prepared IRS Form W-2 places a minister employee at a much higher risk of an IRS audit.
The amount of housing allowance paid is not to be included with taxable wages reported in Box 1 of Form W-2. Instead, as explained in the instructions for IRS Form W-2, it may be shown as an informational item in Box 14 with an accompanying description.
Reporting the housing allowance in Box 14 may be useful for documenting such non-taxable income received for other purposes, such as loan or student financial aid applications. However, it is not a substitute for the required advance designation.
Churches and other non-government employers do not report any amounts in boxes 3 through 6 of Form W-2, since wages paid for services in the exercise of ministry are not subject to the withholding or matching of Social Security or Medicare taxes by the employer. IRC § 3121(b)(8).
For ministers employed by government agencies and performing services in the exercise of ministry, the amount of housing allowance paid is included with Social Security wages (Box 3) and Medicare wages (Box 5). Clergy employed by government agencies are subject to FICA taxes in the same manner as secular employees. Treas. Reg. § 1.1402(c)-5(c)(3). This is true even when a minister is otherwise exempt from Social Security coverage on ministerial earnings as a result of having applied for exemption and having received an approved IRS Form 4361.
However, as stated earlier the amount of housing allowance paid is not to be included with taxable wages reported in Box 1 of Form W-2. This is a common and confusing practice of government agencies employing clergy.
Unlike a housing allowance paid to a minister employed by a church or other non-government entity, the amount of housing allowance paid by a government agency is subject to income tax withholding. As a result, such employers typically take the position that it should also be reported as taxable wages in Box 1 of Form W-2. However, the governing provision is solely for purposes of the collection of income tax at source, and does not address the separate issue of Form W-2 reporting. Treas Reg. § 31.3401(a)(9)-1(c)(3). IRS guidance for government employers regarding this issue appears to be needed.
If a housing allowance is included with wages in Box 1, when preparing Form 1040 the minister’s possible recourse for reporting the excludable amount is to enter it as a negative amount on line 21, ”Other income,” a procedure not authorized by the IRS. A better alternative is to ask the church/employer to issue a Corrected W2-C. Additionally, including the housing allowance in Box 1 makes it impossible for a minister to comply with the authorized procedure for reporting any portion of a housing allowance that may not be excludable in a particular year, as set forth in IRS Publication 517.
How much of a designated housing allowance may an employee exclude from income?
As part of his or her annual income tax preparation, a minister accounts for the amount of designated housing allowance that may actually be excluded from income. The amount that may be excluded in any particular year is limited to the smallest of the following amounts:
Amount designated by the employer in advance of payment
Amount of ACTUAL expenses, spent on qualified housing costs
The fair rental value of the minister’s dwelling including all furnishings, plus the cost of utilities
The fair rental value limitation applies regardless of whether the home is owned or rented. If owned, the minister will need to make a reasonable estimate of rental value based on comparable rentals in the local market.
What types of expenses may a minister consider when requesting a designated housing allowance? (See separate summary doc for a list of legitimate expenses.)
Qualified housing costs include mortgage payments (both principal and interest) on debt to purchase or improve a home, real estate taxes, property insurance, utilities, furnishings, repairs and maintenance, and household supplies. Mortgage interest and real estate taxes may also be deducted as itemized deductions, even when applied to the housing allowance. See separate document for specific allowable expenses.
If a designated housing allowance is not fully excludable from income, how is the non-excludable portion handled?
Any portion of a designated housing allowance not properly excludable from income is required to be included in gross income for the year received. This reconciles through the tax return by adding any such excess to wages reported on Form 1040, line 7. IRS Publication 517 instructs to also report this amount on the dotted line next to line 7 and to enter “Excess allowance” and the amount.
What should a minister attach to his or her annual income tax return to report a housing allowance?
There is no separate form that is included with a minister’s tax return to the IRS, to report a housing allowance, although detailed worksheets should be prepared through the modern tax software. Exclusion of a housing allowance from income is accomplished as the result of the employer not including the housing allowance along with wages reported in Box 1 of IRS Form W-2. If less than the entire amount of a designated housing allowance is excludable for a particular year, then the minister adds the non-excludable portion to taxable wages on Form 1040, line 7, as previously explained.
How does state income tax treatment of a housing allowance differ from federal treatment?
Treatment of the ministerial housing allowance by states that impose an individual income tax varies from state to state. Many states follow the federal treatment without modification of the amount excluded for federal purposes. A Minister may wish to inquire with his or her state revenue department or seek assistance from a local tax practitioner skilled with clergy tax issues.
How does a housing allowance affect an income tax deduction for professional expenses by a minister?
If a minister has unreimbursed professional expenses to report on IRS Form 2106, Employee Business Expenses (flowing through to the SE form), or on Schedule C of Form 1040, Profit or Loss from Business (Sole Proprietorship), if properly classified as self-employed for income tax purposes, and excludes any part of a housing allowance from income, then an adjustment must be made to proportionately reduce the expenses otherwise eligible for deduction. The expenses must be reduced by the ratio that the excluded housing allowance bears to total compensation.
For example, if a minister employee receives a $60,000 salary and $20,000 is excluded from income as housing allowance, then one-third of employee expenses are not deductible (i.e. $20,000/$60,000 = 33%. There is an example of this computation and related tax return attachment in IRS Publication 517.
In the case of a minister employee itemizing deductions, this limitation will have a detrimental effect only if such unreimbursed job expenses, when added to a minister’s other “miscellaneous” itemized deductions, exceeds 2% of adjusted gross income; and only then to the extent that total itemized deductions exceed the applicable standard deduction, i.e. the minister is otherwise able to benefit by itemizing deductions. This currently does not apply, but may come back depending on upcoming possible law changes or if 2017 TJCA (Tax Jobs and Cuts Act/Trump) is not renewed.
Other excellent resources:
Richard Hammar, J.D. LL.M, CPA serves as legal counsel to a mainline denomination. A graduate of Harvard Law School, he is the author of over 30 books on legal and tax issues for churches and pastors. His annual Church and Clergy Tax Guide is excellent.
http://www.daveramsey.com/blog/should-ministers-opt-out-of-social-security/
http://www.guidestone.org/LearningCenter/Ministry/MinistersTaxGuide.aspx
http://www.bpnews.net/3196/ministers-who-have-been-audited-say-follow-irs-rules-carefully
Old cassette tapes by Larry Burkett. Excellent insight on opting out of social security.
Interestingly, Dave Ramsey says he would "exempt/opt out" of social security in a nano-second. (based on the stewardship issue) Additionally, Larry Burkett and Ron Blu also recommend opting out, WITH a comparable retirement savings plan in place.
Note about Estimated Tax Payments and Withholding
While there is NO Fica withheld through your ministry paycheck, your church/ministry employer should be able to withhold Federal and State tax through your regular payroll.
For ministers that have EXEMPTED from social security (with approved 4361) - I recommend withholding at least 10% for federal withholding, and 5% for State (this can be on the “net” salary – gross minus housing allowance). ALL FUTURE MINISTERIAL EARNINGS WILL be exempt. There is no “opting” back in – but…any other income would qualify for regular FICA withholding.
For those who are NOT exempt. They should withhold about 25% for Federal – on the total GROSS salary (SE tax of 15.3, plus income tax of 10%+), and still withhold about 5% for state income tax if applicable.
The IRS considers withholding to have been paid in a timely manner. Estimated payments are logged in on the date received. Withholding is the BETTER option for many reasons.
UPDATED JANUARY 2025
Housing Allowance Designation & Allowable Housing Allowance Expenses
(Summary Doc/Housing Only)
A Housing Allowance is a designated portion of salary, that must be set up and approved by the employee prior to the paid salary, and cannot be retroactive. When setting up your Housing Allowance amount – use a reasonable estimate on the high side. At tax time, we must reconcile, totaling your actual housing expenses. If expenses are greater than allowance – you lose the excess deduction, adding back into income on the tax return. Keep in mind also, that IRS considers reasonable rental fair market value, PLUS all utilities, PLUS all furnishings – when determining “reasonable”.
In my experience, I’ve never seen a minister be able to spend an “unreasonable” amount. Please set your housing allowance request higher than your anticipated expenses.
A housing allowance expense can include anything spent to provide a home for the licensed or ordained minister and their family. The IRS Code and Regulations do not specify the types of expenditures that are included in “providing a home,” but a list is provided in the case of Richard D. Warren, et ux. vs. Commissioner, (114 T.C. 343). While not all-inclusive, this list provides some insight into what the tax court considers appropriate expenses. The following expenses have been allowed as ordinary and necessary expenses to maintain a household:
Rent or principal payments, purchasing costs for the home, and any down payment.
Real estate taxes and mortgage interest of the principal residence.
The expenses can be also used as itemized deductions on Schedule A.Insurance on home and furnishings.
Improvements, repairs, and upkeep of the house and contents, windows, siding, roof
Furnishings, appliances, personal computer, electronics, Kitchen items, dishes
Decorator items, sheets, towels, pillows, decorative, linens
Utilities, including heat, lights, water, cable TV, home phone, trash pick-up, sewer, internet, Wi-fi
Cleaning supplies, cleaning paper products, carpet cleaning, tools for landscaping or gardening.
Hose, brooms, light bulbs, expenses for mower, etc.
Homeowners’ association dues or condo fees.
Interest on the purchase of furniture and/or appliances.
Decorating, painting, and wallpapering.
Carpeting, throw rugs, linoleum, flooring, ceiling tile, ceiling fans
Unallowed Housing Expenses
The following expenses have been disallowed as housing expenses, and fall into the category of ordinary daily personal living expenses:
Maid/cleaning service.
Groceries.
Personal toiletries.
Personal clothing.
Toys, games, computer games.
DVD or VCR movies (but DVD/VCR equipment is allowable)
Cellular phone used outside the home. (Although…this may change)
Home equity loans NOT used for housing-related expenses.
The designated Housing Allowance for the year, SHOULD be found on your W2, in Box 14. If not, please confirm and provide the total Housing ALLOWANCE amount.
ALSO: Provide a total dollar amount of ACTUAL expenses for the year. Backup documentation should be kept with the client’s personal records.