3 Common Mistakes Churches Make When Paying Pastors

Written by Raul Rivera on Apr 26, 2016 in IRS Compliance

Since we are through the brunt of tax season, we can take a moment to breathe a sigh of relief; we all made it through and in one piece. However, before we breathe too deeply, we need to discuss a realization that became quite clear to me this year through our minister’s tax service: there is a shared misunderstanding amongst churches and pastors all across the country with regards to how ministers should be paid and treated for income tax purposes.

This realization actually reminds me of a pastor I met in San Diego, California a few years back at one of our conferences. He was attending the conference along with his church administrator. Upon learning that their church’s payroll might not have been done correctly, they approached me and asked if I would be willing to take a closer look at their church’s payroll.

My response after a brief understanding of their payroll confirmed what they had both feared, which led to astonishment (and frankly, disbelief to a degree) at the situation, because they had hired a local CPA to set up and handle their church’s payroll. Their question to me was, “How could the CPA get it wrong?” And I responded that “it had to do with the fact that a minister has a dual tax status, which can cause much confusion.”

One of the most common mistakes churches make when it comes to payroll is the misclassification of a minister. Whether or not you are receiving compensation from your church as a pastor, this is a post that every pastor and church leader needs to read.

3 pastoral compensation mistakes

Later in this post I will share with you what happened with the church in San Diego. But before I do so, I want to give you the three most common mistakes churches make when paying their ministers a salary.

Mistake #1: Churches treat the minister as self-employed for tax purposes.

Many churches treat the pastor as a self-employed person and assume that they can issue him a Form 1099-MISC. Whenever I talk with churches that operate in this manner I am usually told, “Well, that is the way we have always done things.” Or, I may hear, “That is how we were told to do it by another church that has been around for many years.”

However, the truth of the matter is that issuing your pastor a Form 1099-MISC is not correct and doing so can significantly raise the chances of his tax return being flagged for audit.

You see, when a minister receives a Form 1099-MISC from the church, he will usually report his income on Schedule C and deduct unreimbursed expenses. This causes an incorrect tax return. In actuality, the minister should be treated as an employee for federal income tax purposes and he should receive a Form W-2 showing the wages paid to him by the church.

Mistake #2: Churches treat the minister as an employee for Social Security purposes.

Now this is where understanding ministerial compensation can get kind of tricky. This is because when it comes to Social Security taxes, the minister is considered self-employed, and he is responsible to withhold and pay 100% of those taxes. This self-employment tax is 15.3% of the minister’s gross income.

Unlike the rest of the taxpaying population, when a minister does his tax return he will be responsible to pay federal income tax and self-employment taxes. Let me explain.

The Federal Insurance Contributions Act (FICA) dictates that both an employer and employee are responsible for the FICA taxes. This means that half of the 15.3% tax will be paid by the employer and the other half will be withheld from the employee’s pay. This is not the case for ministers because of their dual tax status as both an employee of the church and self-employed individual for Social Security tax purposes.

It is worth noting that ministers are afforded the privilege of filing for self-employment tax exemption. This is a topic that warrants a post all to itself, so for more information, you can click here.

Mistake #3: Withholding income tax without a voluntary withholding agreement.

Ministers often think that they are exempt from having to pay income taxes. However, that is simply not true. Rather, a minister’s wages are exempt from income tax withholding. In essence, a church should not withhold federal income tax from a minister’s pay without first signing a voluntary withholdings agreement.

According to IRS Publication 517, a minister “can enter into a voluntary withholding agreement with the church to cover any income and self-employment tax that may be due.” However, if the church and minister choose not to enter into a voluntary withholding agreement, then the minister will be responsible to use Form 1040-ES to pay his income tax.

What happened with the church in San Diego?

After spending some time looking more closely at the church’s payroll, I had a phone conversation with the pastor, church administrator, and their CPA to tell them what I discovered. It turned out that the minister had been on the church’s payroll for 2-1/2 years and the church had been withholding FICA taxes from his pay the entire time.

What was even more interesting was that the minister had filed Form 4361 and had been approved by the IRS for self-employment tax exemption. After determining that the church had incorrectly withheld FICA taxes, we were able to assist them in filing Form 941-X returns on the church’s behalf to correct the issue of the last 2-1/2 years.

The result was that the church received a refund of over $18,000.00, which by law had to be split between the church and the pastor.

Help is at your fingertips

Clearly understanding ministerial compensation is of vital importance to both the minister and the church. The fact is that there are many more churches just like the one in San Diego I helped a couple of years ago. Perhaps yours is one of them.

Since understanding ministerial compensation is so vitally important, I want to invite you to join us at one of our Ultimate Church Structure Conferences for a day of learning and growing together. We look forward to seeing you there!

Please feel free to comment. We always appreciate good dialogue. However, we do moderate each comment to ensure that it is on topic and not derogatory to other participants. We ask that you keep your comments brief and pertinent to the topic so that others may benefit.

Raul Rivera

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