Things Pastors Should Know as They Prepare for Tax Season
By Guy Wilcox
Welcome to the StartCHURCH blog! Today we are featuring a blog from tax expert and CPA, Guy Wilcox.
Once again, we approach the end of a tax year. Planning and documenting are the keys to meeting your civic responsibility to pay your lowest possible taxes and steward your finances well. There are a few ways to satisfy both obligations for pastors, and I will share them here and talk through all of the ways you can be most prepared to file your personal tax returns in 2023.
First and most importantly, you must be aware of the foundation of Clergy tax planning which is comprised of the annual compensation agreement with allocations of regular compensation on box 1 of your W-2 and designated housing allowance indicated on box 14. The DHA is a yearly request submitted to the Church or Ministry Board and must be approved by the board at the beginning of each year. An adequately prepared pastoral W-2 will indicate these sources and allocation with no withholding and no FICA/Medicare withholding. The IRS will not object to withholding income taxes; however, this is not advisable, mainly if all employees are Clergy. Once withholding for federal or state is done, the payor is required to file 941 quarterly payroll tax forms. This can allow the government access to otherwise protected activity under the first amendment for Church organizations (note Ministries are not under this protection, but it is still advisable to avoid having to file the quarterly payroll tax returns.) More importantly, and the StartChurch Tax Team sees this all too often, no withholding for FICA/Medicare should ever be applied to Clergy compensation. The government has taken the position that the Church or Ministry employer portion is additional taxable income to the Clergy member being compensated as Clergy.
Allocation of income can also be very advantageous; for instance, the non-taxable housing allowance for income tax purposes helps reduce income taxes. The housing allowance is subject to FICA/Medicare, also called SECA, but not income taxes. Accordingly, we advise Clergy to review all possible and allowable housing costs each year to avoid income taxes or to target a taxable income (more on later). Please note that many Clergy will object to the underlying application of FICA/Medicare and have an opportunity within two years after ordination to entirely opt-out of FICA/Medicare.
So the next question should be, why “target” income levels? There are many items in the social fabric of the tax and entitlement laws that “benefits” are determined based on income amounts. The most evident incident revolves around earned income and other tax credits based on a particular situation. A tax benefit can be lost if the income exceeds the limits defined in the code and regulations. The credit will stand if the target is met using a housing allowance or other legal device. Likewise, for many Clergy, the Affordable HealthCare Act has limitations for subsidies.
It should be noted that the housing allowance is not included in the AHA modified income determination. This can get complicated, and Clergy should work with their tax preparers to best determine their situation. In addition, the Federal government indexes the taxation of social security benefits and increases required costs for Medicare and those nearing retirement. To address these considerations, the StartChurch TaxTeam offers this service on an hourly basis at a discounted rate for existing customers who wish to have assistance in their income tax planning.
Also worth attention is the danger of inflation on its effects on tax planning. Ordinarily, in an inflationary spiral, many also have salary increases to meet the rising costs. Be aware that there is a concept of stealthy bracket creep incident in the progressive tax rates. While your purchasing power is diminished, even with annual indexing, you can end up in a higher tax bracket. Forty years ago, this was a pivotal component of tax planning and investments. There is no way to determine how long this will last, but it is essential to consider these effects on tax planning.
Most organizations should have a documented employee expense reimbursement policy. This allows Clergy to be reimbursed for all legitimate business expenses incurred and paid by Clergy. The advantage of initiating an employee reimbursement policy became very clear after the employee business expenses were no longer allowed as an itemized deduction as, a miscellaneous itemized deduction. A recent tax court summary opinion (Gonzalez, TC Summary Opinion 2022-13) reiterates the value of documentation. In this case, the Clergy meticulously maintained his mileage log and business expenses with complete documentation and successfully received tax-free reimbursements. This will not have an as direct effect on Clergy that file as a contractor, receive a 109, and report their income on Schedule C. However, for Clergy reporting as W-2, the value of doing this correctly is very important.
Retirement planning is often overlooked. Other than IRA contributions, it was difficult and expensive in the past. Non-Profits have 403b plans which work very similarly to 401k plans. Other alternatives are available now, including solo 401k plans and SEP plans. 401k plans will allow contributions limited to $20,500 for 2022 and $22,500 for 2023. SEP plans can provide up to 25% of the regular compensation, are the easiest to operate, and have no annual reports to be filed by the beneficiary and no 401k administrative fees.
For newly ordinated Clergy (within first two years of earning more than $400 from self-employment earnings for Ministerial activities), the exemption from self-employment taxes, including housing allowance and regular compensation where the Clergy determines that it has a conscientious opposition to the acceptance (for services performed as a minister) of any public insurance that makes payments for death, disability, old age or retirement or provides services for medical care, including insurance benefits established by the Social Security Act. This exemption application on Form 4361 is made under this opposition. The benefits are that SECA taxes are avoided, and the subsequent savings can be reallocated to private retirement plans. In addition, please note that this opposition is based solely on ministerial earnings, not on secular earnings. Finally, the ability to participate in Social Security and Medicare upon retirement age is still open for bi-vocational or individuals who have qualified for 40-quarters contributions through other non-ministerial work.
Estate Planning with considerations of Wills, Durable Power of Attorney, and Financial Power of attorney is in place or periodically reviewed and updated. This is less a tax matter for most people but a very clear stewardship responsibility. We recommend you find local estate planning attorneys to draft your documents to ensure that all federal, state and local requirements are met.
If you have any questions about the information shared here, one of our tax experts would be happy to help. Click the button below to schedule a call with one of our Ministry specialists, or call us at (844) 857-6023.