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Tricky Transactions: Housing Allowance Rules and Bookkeeping
By Raul Rivera
The provision of a housing allowance for ministers can be executed in two primary methods. The first method occurs when a church furnishes a parsonage or residential property to the minister as a part of their remuneration package. The second method involves the church allocating a portion of the minister's compensation as a housing allowance. Both forms of allowance are subject to income tax unless there is a prospective designation by the church, documented in the board meeting minutes.
Two Examples of Housing Allowances
In the first example, Nice Church provides Pastor Tom with an annual compensation package of $80,000,
- Has he sought an exemption from self-employment tax?
- Did he live in the parsonage for the entire year?
- Did the church designate any part of his $80,000 as housing allowance to cover some housing costs that may not be paid by the church?
Let’s assume he has not applied to become exempt from self-employment tax and that he lived in the parsonage for the entire year. Let’s also assume that the church designated $10,000 of his $80,000 salary as a housing allowance. Finally, let's assume Pastor Tom paid $6,500 out-of-pocket costs to live in the parsonage. He calculated it using the housing allowance worksheet, which allows for utilities, lawn service, and internet.
Here is how the church will report Pastor Tom’s W-2 and how he will prepare his Income Tax Return.
- To determine Pastor Tom’s compensation for Federal Income Tax purposes, the church will enter $70,000 into line 1 of his W-2 form and $39,500 into line 12 of his W-2. The reason they entered $70,000 into line 1 is because they designated $10,000 of his salary as housing allowance.
- Now, Pastor Tom is responsible for determining how he reports these amounts on his tax return. First, he must determine how much of the $10,000 he used to provide a home for himself and his family. He used $6,500 of the $10,000 to pay utilities and other housing costs. That means he can exclude $6,500 of his $80,000 salary from his tax return. He does so by reporting $73,500 as income on line 1 of Form 1040. Now for the next step.
- If Pastor Tom had applied to be exempt from self-employment tax, he could have skipped this step, saving him $15,472 yearly in taxes. However, since he has not applied to the IRS to be exempt from self-employment Tax (IRC 1401), he must pay self-employment tax on his salary and the parsonage allowance. The way he determines this is by adding (Salary + Parsonage). In his case, it is $80,000 + $29,500 = $109,500. He must report $109,500 on line 5a of Schedule SE. Then he will have to calculate his self-employment Tax using the following formula provided on schedule SE:
(Total income * .9235) *.153 = X
In his case, it is (109,500 * .9235) * .153 = $15,472
In addition to paying federal income tax on $73,500, he will also be required to pay self-employment tax, which in his case amounts to $15,472
The second example is Good Church and Pastor Larry. His salary at the church is $98,000. The church doesn’t own a parsonage; instead, they rely on IRC 107(2) to allow him to take advantage of the housing allowance. Because Pastor Larry owns or rents his own home, the questions he must consider are as follows:
- Has he applied to be exempt from self-employment tax?
- How much of his salary did the church designate as housing allowance?1
Here is how Good Church does it. The board of directors approved his salary of $98,000 and designated the entire $98,000 as housing allowance. When the tax year ended, Pastor Larry used the Housing Allowance worksheet from our Compensation Suite App and filled it out completely. He determined that the actual cost for him to live in the house he and his wife own was $33,600 per year. Using the worksheet, he determined the fair rental value was $42,000. Lastly, the worksheet allowed him to enter the amount the church designated to him as a housing allowance, which was $98,000. To summarize, he came up with three numbers as listed below:
Actual cost to provide a home: $33,600
Fair rental value: $42,000
Amount designated by church: $98,000
Even though the IRS is not a Christian organization, they sometimes talk like they are. In preachers’ terms, IRS rules state that whatever you do unto the worksheet is the “least of these” you are allowed to claim. In pastor Larry’s case, it is $33,600.
Here is how the Good Church will report Pastor Larry’s W-2 and how he will prepare his Income Tax Return.
- The CFO at Good Church is savvy and knows that the best way to prepare the W-2 for Pastor Larry is to wait until he receives a copy of the signed Housing Allowance worksheet. Once in his hands, he will follow IRS rules and look for “the least of these” numbers on the worksheet.
- The CFO reports $64,400 on line one of the minister’s W-2 form and $33,600 on line 12. Even though the church designated $98,000 as his housing allowance by simply waiting for Pastor Larry to turn in his worksheet, the church can very easily prepare a W-2 form for him to file his taxes.
- Pastor Larry is responsible for determining how he reports these amounts on his tax return. He reports $64,400 on line 1 of his Form 1040. He is done.
- Because Pastor Larry filed under IRC 1402 to be exempt from self-employment tax of Section 1401, he doesn’t have to report the $98,000 of his salary on Schedule SE.
- Pastor Larry simply reports his income on line 1 of Form 1040 and takes all the deductions afforded to him, such as interest on his house, property taxes, donations, and others that may apply.
Which Pastor Paid More Tax?
When I look at both pastors, there is a striking difference between the two regarding taxes. Even though Pastor Tom’s compensation package was worth $11,500 more than Pastor Larry’s, Pastor Larry got to keep more of his money.
Pastor Tom |
Pastor Larry |
|||
Salary |
80,000 |
Salary |
98,000 |
|
Parsonage |
29,500 |
Housing Allowance |
Designated |
|
Total Compensation |
109,500 |
Total Compensation |
98,000 |
|
Income Tax |
8,011 |
Income Tax |
7,728 |
|
Self-employment Tax |
15,472 |
Self-employment Tax |
0.00 |
|
Total Tax Paid |
23,483 |
Total Tax Paid |
7,728 |
|
|
After Tax Cash Kept |
56,517* |
After Tax Cash Kept |
90,272 |
|
*$80,000 (Cash Compensation) - $23,483 (Total Tax Paid) = $56,517
Let StartCHURCH be Your Compliance Partner
In conclusion, the tax implications of housing allowances for ministers like Pastors Tom and Larry show us how tricky clergy compensation and proper record keeping can be. We provide a minister’s compensation agreement service that takes the guesswork out of the way. While Pastor Tom’s higher total compensation resulted in a more significant tax burden, Pastor Larry’s strategic use of exemptions allowed him to retain a greater share of his income. This comparison serves as a crucial reminder to churches and their ministers of the potential benefits of understanding and utilizing tax laws to their full extent. We are honored that thousands of churches and ministers across America trust us as their compliance partners. Feel free to give us a call at 770-638-3444.
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Some churches pay the minister a fixed salary; then they also pay him a housing allowance. While this is not wrong, it usually results in the minister not getting the full benefits that IRC 107(2) provides, or worse yet, it results in the minister underreporting income, which is unlawful and can result in severe penalties.