• Federal Taxation of Ministers (income and self-employment, i.e., Social Security)
• Group Federal 501(c)(3) Tax Exemption
• Unrelated Business Taxable Income
• Substantiating and Reporting Charitable Contributions

Throughout this chapter and the entire Legal Manual generally, you will see references to Richard Hammar's Church & Clergy Tax Guide (Hammar's Tax Guide. This is a useful resource we highly recommend. It is written for nonlawyers and lawyers alike. It is updated each year to include the latest changes in the federal law. If you want more detailed information regarding the subjects discussed in this section, we advise you to consult Hammar's Tax Guide. In addition, you may wish to share it with your attorney, accountant, or tax provider. For copies call (800)222-1840 or visit the "Bookstore" at ChurchLawToday. Copies are $39.95 each.

• Federal Taxation of Ministers
• Self-Employment Tax
• Federal Income Tax
• Status of Ministers (Employee versus Independent Contractor)
• Housing or Manse Allowance
• The Presbyterian Church ( U.S.A.) Group Federal 501(c)(3) Tax Exemption
• Intermediate Sanctions
  • Intermediate Sanctions Summary
• Disclosure Regulations
• Sample Section 6104(d) Disclosure Statement
• Restrictions on Political Activity and Lobbying
• Unrelated Business Income Tax
• Excise Taxes
• Substantiating and Reporting Charitable Contributions
• Substantiation
• Quid Pro Quo Rules
• State Related Tax Issues
• Sales and Use Taxes
• Property Taxes and Related Matters
• Challenges to Church Property Tax Exemptions
• Taxes vs. Assessments
• Local Taxing Requirements
• Tax Resources
• Sample Manse Allowance Forms
• Housing Allowance Notification by Church to Minister —
• Housing Allowance Insert for Minutes of Meeting —
• Polity Note #24: Tax Status for Commissioned Lay Pastors
• Polity Note #69: Minister Employer
• Private Letter Ruling Regarding Methodist Deacons

This section, Federal Taxation of Ministers, covers a wide variety of topics that can be grouped into two main categories: self-employment taxation (i.e., Social Security) and income taxation. It is vital to remember that these taxes and the rules and regulations under which they are administered are separate. Definitions used for income tax purposes are not the same as the definitions used for self-employment tax purposes.

However, the rules discussed in this section pertain to ministers as defined by the Internal Revenue Code ("Code"), and this definition is the same for both self-employment and income taxation purposes. A "minister" is one who:

1. administers sacraments,
2. conducts religious worship,
3. has management responsibility in a local church or religious denomination,
4. is ordained, commissioned, or licensed, and
5. is considered to be a religious leader by his or her church or denomination

The Tax Court, in 1989, ruled that only the fourth factor is required and that a balancing test should be applied with respect to the other factors. (See Hammar's Tax Guide.) In addition, if a church or denomination ordains some ministers and licenses or commissions others, anyone licensed or commissioned must be able to perform substantially all of the religious functions of an ordained minister to be treated as discussed in the remainder of this section. This statement begs a discussion of whether the Presbyterian Church (U.S.A.)'s Commissioned Lay Pastors ("CLPs") are "ministers" as defined by the Code and, therefore, qualify for the special tax treatment outlined by the Code.

In December 1998, the United Methodist Church secured a Private Letter Ruling ("Methodist Private Letter Ruling") from the Internal Revenue Service ("IRS") pertaining to its ordained deacons. A copy of the Methodist Private Letter Ruling is included at the end of this chapter. In it, the IRS concludes the three deacons discussed are "ministers" as defined by the Code and applicable case law.

You will see from reading the Methodist Private Ruling Letter that a private letter ruling only applies to the taxpayers who requested it. However, it is common for taxpayers and their tax advisers to rely on private letter rulings because they are a good indicator of how the IRS would respond in an audit or tax proceeding with regard to a particular question presented. It is for this reason we provide a copy of the Methodist Private Letter Ruling for your review.

What does this Private Letter Ruling mean for CLPs? As outlined in PC(USA) Polity Reflections Note #24, written by the Office of the General Assembly's Office of Constitutional Services, it appears that CLPs who perform substantially all of the duties allowed pursuant to the Book of Order are similarly situated to the three Methodist deacons discussed in the Methodist Private Letter Ruling because they are (1) commissioned and (2) perform similar functions as that of a Methodist minister. Therefore, it appears that CLPs performing services such as those outlined in the Methodist Private Letter Ruling and Note #24 would be defined as "ministers" pursuant to the Code and should be treated the same as Ministers of the Word and Sacrament are for federal tax purposes. As used in the remainder of this Tax section, the term "minister" refers to those who meet the Code's definition of a minister.

Each tax year, the Office of Legal Services is questioned concerning the tax issues of individual ministers. The first step is to clarify which tax the minister is questioning, self-employment or income, and to be sure the minister does not assume that self-employment tax regulations apply to her or his federal income tax status. We will discuss these two taxes and explore the impact of the 1995 Weber decision as it pertains to Presbyterian ministers. Other income taxation topics are also addressed.

Ministers with net earnings from self-employment of $400 or more are subject to self-employment tax. The definition of "net earnings from self-employment" is the gross income from a person's trade or business less allowable deductions attributable to the trade of business. In relation to ministers, compensation received for services performed in the exercise of their ministry is considered to be self-employment income for purposes of the self-employment tax (i.e., Social Security tax). The Internal Revenue Service guidelines state that the following services by a minister subject her earnings to self-employment tax:

1. Conduct of religious worship or of sacerdotal functions (Holy Communion, baptism, etc.). This conclusion is reached even where worship is conducted or sacraments performed for a nonreligious organization, such as an educational institution.
2. Services performed for a qualifying integral agency of the religious denomination, such as a governing body or agency.
3. When a minister is assigned to perform services for an organization that is neither a religious organization nor operated as a religious agency, these services are nonetheless considered to be qualifying services for self-employment tax purposes. Though no sacerdotal functions are performed and no religious worship is conducted, this result is reached because the minister is assigned to perform these services by her or his presbytery.

Note: Qualifying services do not include services performed by ministers who are employees of any governmental agency, such as armed forces or prison chaplains, though they are performing sacerdotal services. Their services are considered performed as government employees rather than as self-employed persons within a religious denomination.

Estimated tax is the method used to pay income and self-employment taxes. You can determine your estimated tax by using the worksheet Form 1040-ES. The minister will be allowed to deduct one-half of her self-employment payments from taxable income for federal income tax purposes. Internal Revenue Service Publication 517, Social Security and Other Information for Members of the Clergy and Religious Workers — , is useful in addressing general and specific filing questions. IRS forms and publications are also available by calling (800) 829-3676.

Ministers serving as teachers or administrators often have a difficult time determining whether or not they are performing qualifying services. If they are assigned to their duties in furtherance of their ministry by their presbytery, their services are considered qualifying whether they perform sacerdotal functions or not. If they are not assigned to those duties by their presbytery, then whether they perform sacerdotal functions becomes critical. In other words, a professor of mathematics at a university that is considered an integral part of the denomination would be performing qualifying services and would be receiving self-employment income. However, a professor of mathematics at a secular university who is not assigned there by her presbytery and does not perform qualifying services is not receiving self-employment income. In the latter case, her employer, the university, would withhold Social Security taxes, as it would for any employee. However, a minister who works for a non-denominational university as a chaplain and who devotes her entire time to the duties of a chaplain, including conducting worship, performing sacerdotal services, counseling students, or perhaps teaching a course in religion, would be considered to be performing qualifying services and receiving self-employment income. She would pay the self-employment tax and the university would not withhold Social Security taxes from her salary.

Examples cited above are derived from past IRS Revenue Rulings. These rulings are issued on areas of broad interest from a representative fact situation. The scope of the ruling is limited, however, to similar fact patterns. Because each fact situation is different, a minister with a particular problem may be well advised to seek a Private Letter Ruling on the facts of her or his case if so advised by competent tax counsel.

Net earnings of ministers from self-employment to which the self-employment tax rate is applied include the fair rental value of any manse furnished to a minister or the rental allowance (and utility allowance) paid to the minister, though these are excluded from gross income for Federal Income Tax purposes by Internal Revenue Code § 107. Ministers are also required to include for self-employment tax purposes the value of meals and lodging furnished for the convenience of their employer, again, though Internal Revenue Code § 119 permits exclusion of the value to these meals and lodging for calculating Federal Income Tax. All deductions attributable to a minister's work must be claimed in the minister's calculation of his or her net earnings subject to self-employment tax. These deductions would include such items as home office expenses, subscriptions to professional journals, and travel expenses.

Prior to 1968, Social Security coverage for ministers, which is funded by the self-employment tax, was elective. If coverage were not elected, Social Security coverage was not provided. However, for all years since 1967, clergy are automatically covered under Social Security unless they receive an exemption from the IRS. IRS Form 4361 must be filed by those seeking the exemption. Form 4361 includes a statement that the applicant is either conscientiously opposed, or opposed because of religious principles, to acceptance of any public insurance, including Social Security benefits, based on her services as a minister. In order to seek the exemption, persons in ministry prior to 1968 and newly ordained ministers since 1968 have until the due date for their second tax return that included more than $400 of net earnings from self-employment, some of which were from the ministry, to file Form 4361.

In view of the 198th General Assembly's (1986) approval of a Pastoral Letter to Candidates Regarding Social Security, which strongly supports participation in the Social Security program, it will be difficult for Presbyterian Church (U.S.A.) ministers to meet these requirements in order to secure the exemption. They must rely solely on personal grounds of conscience when applying for exemption. The Legal Office does not recommend seeking exemption from Social Security. Loss of access to Social Security disability payments (and other death benefits), the increased cost of Medicare participation if one must buy one's way back into Medicare, and the fact that Board of Pensions' benefits plans within the denomination assume receipt of Social Security benefits as part of one's retirement package suggest that the long-term financial risks of nonparticipation in Social Security are significant. Opting out of Social Security can also create a hardship on a surviving spouse when the minister dies.

Once obtained, this exemption from Social Security coverage is irrevocable. (A limited exception to irrevocability was previously available to those ministers choosing to file the required form and to pay self-employment tax for 1986 and/or 1987, but that period of availability ended for nearly all on April 15, 1988. The Ticket to Work and Work Incentives Improvement Act of 1999 provided another revocation opportunity. Under the law, a minister was able to revoke her prior exemption by filing an application no later than the due date of the federal income tax return for her or his second taxable year beginning December 31, 1999 (i.e., April 15, 2002). It is unkown whether Congress will again provide such an opportunity to revoke one's exemption from Social Security coverage.

Those seeking to be excluded from Social Security must file Form 4361 as soon as possible (within two years) after beginning work as a minister and should never discard the original filing or any Internal Revenue Service responses. There can be serious problems if these documents are unavailable in the future. A detailed explanation of the exemption process is set forth in Internal Revenue Service Publication 517 as well as in Hammar's Tax Guide. In addition, the Board of Pensions has a release form, Form ENR-900, which must be completed. You should contact your Board of Pensions representative to secure a copy of this form. Again, the Legal Office does not recommend seeking exemption from Social Security.

1. Hammar's Tax Guide,
2. the United Methodist Church's case decided by the 4th Circuit Court of Appeals in 1995, Weber v. Commissioner, 60 F.3d 1104, and
3. a note in Polity Weekly issued by the Office of the General Assembly's Office of Constitutional Services.

In his Tax Guide, Richard Hammar advises "that most clergy should report their federal income taxes as employees, since

1. the value of various fringe benefits will be non-taxable,
2. audit risk is much lower,
3. reporting as an employee avoids the additional taxes and penalties that are often assessed against clergy who are reclassified as employees by the IRS,
4. the IRS considers most clergy to be employees, and
5. most clergy are employees under the tests applied by the IRS and the courts." (Hammar's Tax Guide)

In 1995, the 4th Circuit Court of Appeals issued Weber v. Commissioner, 60 F.3d 1104. That case addressed the issue of whether United Methodist clergy at the local church could file as self-employed for income tax purposes and use Schedule C. While this opinion did not involve a Presbyterian minister, it provides helpful information regarding the issues the court found to be important in making a decision regarding ministers and employee versus independent contractor status for income tax purposes. The Weber court found the seven following points significant in determining Weber an employee:

1. the degree of control exercised over the details of the work by the "employer,"
2. which party invested in the facilities used in the work,
3. the opportunity of the "employee" for profit or loss,
4. whether the "employee" could be discharged by the "employer,"
5. whether the work was part of the "employer's" regular business,
6. the permanency of the relationship between the parties, and
7. the relationship the parties believed they were creating.

Presbyterian ministers in local churches may wish to compare their employment situation to Weber's employment situation.

Finally, the Office of Constitutional Services has issued Note 69 (September 9, 1992) in its Polity Weekly series which discusses the issue of who is the employer of a Presbyterian minister in a local church setting. In it, they determine the session is the employer of the minister. A copy of this note is included at the end of this Taxation section for your reference.

It is important to remember the rules pertaining to self-employment (i.e., Social Security) taxation of ministers have nothing to do with the rules on income taxation of ministers. Different rules, regulations, and definitions of status are used in the two systems. Confusion will result if one mixes self-employment tax definitions with income tax definitions. For purposes of federal income taxation, the determination of one's status as either employee or self-employed person is left to the individual, although ministers serving at a local church are advised to file as employees in light of the above-discussed Polity Weekly note, Hammar's advice, and the Weber decision. Remember that for self-employment (i.e., Social Security) tax purposes, ministers are defined as self-employed by statute. No comparable statute exists for the determination of income tax filing status.

Prior to 2002, section 107 of the Internal Revenue Code ("Code") stated:

In the case of a minister of the gospel, gross income does not include — (1) the rental value of a home furnished to him as part of his compensation or (2) the rental allowance paid to him as a part of his compensation, to the extent used by him to rent or provide a home and to the extent such allowance does not exceed the fair rental value of the home, including furnishings and appurtenances such as a garage, plus the cost of utilities.

In 1971, the IRS issued Revenue Ruling 71-280 which held that the manse allowance of ministers who owned their homes could not exceed the fair rental value of the furnished home plus utilities. The result of this Revenue Ruling was to limit the manse allowance to the lesser of the following three amounts: (1) the amount designated in advance by the minister's employer, (2) the actual cost of providing a home, or (3) the fair rental value of the furnished home plus utilities. Many tax professionals and ministers understood the Revenue Ruling to be an interpretation of what Congress meant in enacting section 107 of the Code, and a large group of minsters, therefore, filed their taxes in accoradance with this understanding and further limited the amount excluded from income by the fair rental value of their furnished home plus utilities.

However, a minister named Rick Warren adopted a more aggressive position regarding the amount allowable as housing allowance by asserting that the revenue ruling's further limitation on the allowable manse allowance did not apply. He, therefore, excluded from his income the lesser of the designated amount or the amount actually spent providing a home. The Internal Revenue Service audited the Rev. Warren's returns and challenged the amount he claimed as manse allowance. The Tax Court sided with Warren stating that the annual "fair rental value" test the IRS adopted in 1971 was not a valid limitation on manse allowances. Warren v. Commissioner, 114 T. C. 23 (2000). The Internal Revenue Service appealed this decision to the Nineth Circuit Federal Court of Appeals in California. The Ninth Circuit then did something no other court has done in a manse allowance case. In a decision of a three-judge panel, it issued an order which, in part, asked a third-party, a law professor, to provide a brief outlining whether the manse allowance provided in the Code is constitutional, signaling that the court had determined the manse allowance might be unconstitutional.

Congerss responded quickly to this threat to the manse allowance by enacting the Clergy Housing Allowance Clarification Act of 2002. The effect of this act was to codify the further limitation of the manse allowance to include the fair market rental value of the furnished home including utilities. Therefore, section 107 of the Code currently states:

Two requirements must be met by ministers in order to qualify for the income exclusion as defined above. First, one must be a "minister." (See discussion at the beginning of this section.) Second, a properly established housing allowance must be set up for expenses used to rent or to provide a home for the minister.

The allowance giving the use of the manse or setting a specific amount must be designated in advance by the employing body; retroactive designation of a housing allowance is prohibited and in such cases the exclusion will be disallowed. Expenditures for such things as rent, down payment, mortgage installment payments, closing costs, mortgage interest, real estate taxes, special assessments for such purposes as streets and sewers, garbage removal, utilities, repairs and maintenance, fire, theft and accident liability insurance, and home furnishings may be qualifying "costs of providing a home." If any of these expenses are larger than the amount designated, the excess amount may not be excluded. Any part of the housing allowance spent in connection with business or income property owned by the minister, in addition to his or her home, does not qualify for the exclusion and must be included in gross income. Any part of the allowance spent on items not directly related to renting or providing a home, such as the purchase of food, clothing, or maid service, is not excludable from gross income. Unless the amount designated as housing allowance is actually used for the intended purpose, it is not excludable from gross income.

The allowance amount permitted to be excluded from gross income also may not exceed the fair rental value of the property. The fair rental value is defined in Revenue Ruling 71-280 as the amount of rent that an unrelated party would pay for the home, including furnishings and related structures, such as garages, plus utility costs. Internal Revenue Service Publication 517 states:

If you own your home and you receive as part of your pay a housing allowance, you may exclude from gross income the smallest of the following:

• The amount actually used to provide a home,
• The amount officially designated as a rental allowance, or
• The fair rental value of the home, including furnishings, utilities, garage, etc.

For example, if the housing allowance is $500 per month and the fair rental value of the furnished home plus utilities is $400 per month, only $400 a month may be excluded from gross income pursuant to § 107. The excess $100 a month must be included in gross income, even though it had been designated as housing allowance.

The church can document the required advance designation of housing allowance in a contract, minutes, budget resolution, or any other appropriate instrument evidencing an official action designating a specified amount for the housing allowance in advance of payment of the allowance. Suggested forms for this procedure are included at the end of this chapter. Hammar's Tax Guide has additional samples. If a church has more than one minister, the qualification of each for the exclusion is determined on an individual basis. A specific designation is required for each minister rather than a general designation for all the ministers. This requirement has been affirmed in the Tax Court case of Boyer v. Commissioner, 69 T.C. 521 (1977).

Other specific points of interest relating to housing allowances are:

1. It is immaterial whether the housing allowance is paid separately or as part of the overall compensation for the minister, providing the allowance is properly designated in advance. In other words, one check may be used to pay the minister's salary and her or his housing allowance and the allowance will be excludable from her or his gross income if the allowance was properly designated in advance.
2. Designation of a minister's entire salary as a housing allowance will not necessarily permit exclusion of her or his compensation from income tax. Only the amount the minister actually spent for providing a home (up to its fair rental value as described above) may be excluded from gross income for federal income tax purposes.
3. Persons not specifically ordained, licensed, or commissioned by the denomination do not qualify for the housing allowance exclusion. Religious workers such as a "minister of music" or ?minister of education" who are not ordained, perform no sacerdotal functions, and who are not commissioned to conduct worship in a congregation do not qualify for the exclusion.
4. The overall amount that is designated for the housing allowance exclusion must be reasonable. Remember that "fair rental value" includes furnishings and utilities. Where a furnished manse with paid utilities is provided, there still may be some "costs of providing a home" (such as furniture provided by the minister) that are out-of-pocket expenses. Remember, however, items that could be designated as personal (e.g., a video game machine and toiletries), rather than related to the home, are unlikely to withstand audit scrutiny.

Note: Interest and taxes paid by the minister on her or his owned primary residence qualify as itemized deductions from income in addition to the housing allowance exclusion. A minister may use her designated allowance to purchase, rather than rent, a home and then deduct interest and taxes paid on her personal residence as itemized deductions on her tax return, as well as having the housing allowance excluded under Internal Revenue Code § 107. Internal Revenue Service Ruling 83-3 attempted to eliminate this "double benefit," but it was restored in the 1986 Tax Reform Act.

Retired ministers may qualify for the housing allowance exclusion if they satisfy the same requirements as active ministers. If the employing church or other qualifying organization provides a retired minister with a rent-free home or a housing allowance in recognition of her past services, Revenue Ruling 63-156 makes the exclusion available to him or her. The exclusion is available only to retired ministers themselves and is not transferable to other persons, such as surviving spouses. In addition, Internal Revenue Service Publication 517 states, "[t]he retirement allowances you receive as a retired minister are not earnings from self-employment for self-employment purposes." Retired Ministers who receive benefits from the Board of Pensions will be eligible, in most cases, to have some or all of their benefits designated in advance as a housing allowance. (See the Board of Pensions 2003 Tax Guide for Ministers & Churches distributed in early 2003, p. 10.)

Further, the Small Business Job Protection Act of 1996 has confirmed that the portion of a minister's retirement distribution from a church plan, properly designed as a housing allowance, is not subject to self-employment taxes. In addition, this law allows a minister who works in certain "nonchurch" jobs fulfilling his or her ministry, such as chaplain, to now participate in a church retirement plan.