The IRS scrutinizes churches and ministries, so it’s imperative that you run a ‘tight ship’ in the finance department. Over time, ships get leaky if you don’t maintain them, so here are indicators that your ship may be ‘leaky’ and need fixing:

1. Not reporting all taxable income for church staff. Examples include love offerings, gifts of property, expense allowances (such as for a car or entertainment), reimbursements for self-employment social security for pastors, and paid benefits (such as life insurance). All of the examples must be treated as regular taxable income. Failure to report allowances as income can result in a 200% fine on the allowance amount, (an excess benefit transaction) plus penalties and interest. And, board members who approved the allowance are subject to personal fines of up to $10,000.
2. Unsubstantiated expenses. Expenses reimbursed on an expense report must include the place, time, amount, business purpose and business relationship of all present. If expenses are reimbursed but unsubstantiated, then the amount needs to be reported as taxable income to the person who received the reimbursement.
3. Not accounting correctly for special events. If the church awards prizes for raffle drawings, a Form 1099 or W-2G is needed if the amount of the prize exceeds $600 and is at least 300x the wager. You need to get a payment from the winner that’s treated as withholding and deposited with the IRS if the prize amount is greater than $5,000. (These are general rules; please talk with us or refer to the IRS for specifics.) If the church issues a receipt for a dinner fundraiser, a distinction is needed regarding the hard cost of the dinner in relation to the entire ticket cost.
4. Not having detailed records for housing allowances for ministers. It’s important to keep updated records regarding fair market rental values and agreed upon housing allowance amounts. The church is responsible for record keeping with regard to the designation, but the minister is ultimately responsible for record keeping of the actual expenses and the non-taxable portion.

Compliance is an ongoing task. Be sure to stay on top of your recordkeeping and talk with your CPA whenever you have questions.

Ministers are able to claim many housing expenses as exclusions for income tax purposes. If you’re gathering information for your tax return or to provide to a tax preparer, here are 11 exclusions you can take:

• Mortgage payments (interest and principal)

• Real estate taxes

• Property insurance

• Utilities (gas, water, electricity, sewer, garbage pickup, local telephone service)

• Appliances and furniture (purchase, rent and repairs)

• HOA dues

• Pest control

• Yard maintenance and improvements

• Maintenance items (household cleaners, light bulbs, etc.)

• Down-payment on a home

• Remodeling expenses

There are also some housing expenses that are denied. Avoid claiming these five:

• Cleaning service

• Food

• Domestic help

• Expenses on a second home or vacation home

• Home equity loan payments (unless used to pay for housing expenses such as remodeling)

Please remember your claimed housing allowance is the lesser of these actual expenses or the church-approved amount. Therefore, our recommendation is to estimate a little high for the amount you submit to, and what’s ultimately approved by, the church.

In June, 2011, I wrote a blog post about a minister who claimed two residences with his parsonage allowance – a primary residence and a lake house. The IRS wanted to deny the exclusion for two residences, even though both residences met the criteria. The Tax Court had cross-referenced the Dictionary Act, arguing that the definition of a ‘home’ could also mean ‘homes’ if the condition for residence is met. The Tax Court supported the minister’s exclusions and so the ruling stood that both residences qualified for excluding the allowance from income.

On February 8, 2012, the Court of Appeals for the Eleventh Circuit reversed the Tax Court decision, siding with the IRS. The Eleventh Circuit Panel cited that cross-references to the Dictionary Act are made for convenience and do not constitute law. They also stated that the legislative history of the Internal Revenue Code referring to the housing allowance at the applicable time period (Code Sec. 107 applying to 1996-1999) repeatedly referred to a dwelling as a singular entity.

Obviously, these challenges can continue for years before resolution since it appears that the minister will appeal the Panel’s ruling.  Obviously, the more conservative approach is to claim only one home in the housing allowance calculation.

For more detail about housing allowances, refer to a complete description in two blog posts – part 1 and part 2.

It’s January, so administrators everywhere are scrambling to prepare Form W-2 for employees. For ministers, there are two items that can be easily overlooked as income: love offerings and allowances that are not housing-related.  So, before you issue your pastor’s Form W-2, ask questions about these items:

Love offerings – What is the amount of monetary gifts given directly to the pastor from church members and attendees? Was the pastor given tangible gifts, such as airline tickets, vacation home usage, property such as a car, televisions or computers? If yes, the value of the gift is considered taxable income.

Allowances – The housing allowance is tax-free. Read about the rules of housing allowances to make sure that your church is in compliance. Other allowances are considered taxable income. Examples include car payment, maintenance and gasoline, utility bills, cell phone, insurance and gifts purchased for others.

Failure to report allowances as income can result in a 200% fine on the allowance amount, (an excess benefit transaction) plus penalties and interest. And, board members who approved the allowance are subject to personal fines of up to $10,000.

The taxable allowance can be partially offset with a reimbursement policy that documents church-only usage of the item, such as a car and related costs. Such an accountable reimbursement policy requires strict documentation, but can benefit the pastor with non-taxable reimbursements. This reimbursement policy is not retroactive, so such a policy may need to be put in place for expenses going forward, but the allowances need to be reported as income for the previous tax year(s).

Last week’s blog gave you the IRS’ rules regarding income tax exclusions for housing allowances.

It’s the minister’s responsibility to maintain written records that document 1) fair market rental value, 2) agreed upon amount, and 3) actual amount needed to provide a home. The church is responsible for recordkeeping and reporting, but the minister is ultimately responsible for the housing allowance taken. The minister’s tax return is subject for audit for up to three years after filing.

The church needs to keep updated records that detail how the designated housing allowance was determined. This documentation belongs in the minutes of the meeting when the amount is decided, which should be prior to January 1^st. Many churches will be liberal in calculating the designated amount since the minister will only be able to take the lower of the three options.

Ministers can claim a portion of income tax-free as a housing allowance. But, you must follow specific guidelines and then report and maintain the allowance. Reporting and maintenance will be covered in next week’s post as Part 2.

The rules regarding housing allowances are:

• Housing (also called parsonage or rental) allowance for ministers is excludable from gross income for income tax purposes, but is not excludable from the self-employment tax which affects ministers.
• The amount excludable is the least of these three amounts:
  • Fair market rental value (including furniture, utilities, garage, etc.)
  • Agreed upon/designated allowance
  • Actual allowable costs incurred
  • Whether renting or owning, the exclusion amount cannot be more than what is considered reasonable pay for ministerial services.
  • The amount of allowance that is not eligible for exclusion is considered part of wages for income tax purposes (Form 1040, line 7).

Housing allowances for ministers are one of the red flags for the IRS. Failure to follow the rules exactly can result in taxes, penalties and interest.

In 2010, a Tax Court ruled that a minister is not limited to one principal residence for purposes of the housing/parsonage allowance exclusion.

The minister excluded the parsonage allowance paid by his employer on two primary residences.  In contrast, the IRS had said the minister could only exclude a parsonage allowance, paid by the minister’s employing ministry, on his primary residence even though the minister/taxpayer had a second home at a nearby lake.   This second home met the use criteria, as defined in the Internal Revenue Code (Code), to otherwise be considered a personal residence.

The Tax Court sided with the minister, and in a divided opinion, said the IRS sought to substitute the phrase “a single home” or “one home” for the phrase “a home” that is currently in the Code.  The Court found no basis for the IRS’ position; in fact to the contrary, it said the Code talks about words in the singular which can and do have the connotation of a plural meaning.

The finding will likely be appealed to the applicable Circuit Court of Appeals by the IRS and then to the Supreme Court if it does not prevail in the Circuit’s Court of Appeals. However, ministers can rely on the Tax Court’s opinion, for now, if they want to claim a housing or parsonage allowance on applicable personal residence(s).

Obviously, a thorough discussion with one’s legal and tax counsel is highly recommended given the IRS’ position on this topic.