What You Need to Know About Your Pay, Part 1

By Raul Rivera

As we get ready to head into the month of May, it is safe to say that the brunt of tax season has surpassed us. During this tax season, our CPAs at StartCHURCH were able to help hundreds of pastors and ministers file their federal and state tax returns. One of the things that we do on an ongoing basis is to help pastors understand the intricacies of ministerial compensation. Because of this, many of our clients are able to take advantage of the various benefits granted to ministers in the tax code, and as a result, the pastors we serve sleep well at night knowing that their finances and taxes are done right. However, we have noticed that when there is a lack of understanding the complexities of ministerial compensation, ministers often suffer the consequences of overpaying on their taxes.
Now, this misunderstanding of ministerial compensation does not only fall upon the pastors and ministers themselves, but also upon working professionals such as CPAs and tax attorneys. It is not uncommon for us to hear our clients say, “Well, my CPA told me that I didn’t have to worry about that”, or “My attorney told me that that didn’t apply to me as a minister”. It is not that these CPAs and tax attorneys are malicious and purposefully giving out faulty advice. It is just that most of these professionals work very little with churches and ministers on a regular basis, and unless you do, it can be easy to misunderstand ministerial compensation and the difficulties that come with it.
It is for this reason that I feel it is necessary to write a blog post on this topic. However, it will be written in two parts. Within the first part of this series, we will spend some time defining compensation. In order to properly understand ministerial compensation, it is necessary to understand what is considered taxable income. We will also look at a common misconception that many pastors and ministers have regarding their compensation, as well as what ministerial compensation encompasses. Then, in the second part of this series we will take time to explain how ministerial compensation should be determined. But first, let us look at how the IRS defines taxable income.

Defining income

If you were to ask a handful of people to give you their own definition of income, you would more than likely receive a handful of different definitions. Although there may be a general consensus of what income is, it is in the consideration of what is taxable that we begin to see a differentiation among the definitions. This is especially true with ministerial compensation, and it is for this reason that we need to know how the IRS defines taxable income.
In general, taxable income is the gross income of an individual or corporation, minus any allowable tax deduction. In other words, your taxable income is the amount of your income that is subject to income tax.
Regarding gross income, subsection 61(a) of the Internal Revenue Code says,
“Except as otherwise provided in this subtitle, gross income means all income from whatever source derived, including, (but not limited to) the following items:

1. Compensation for services, including fees, commissions, fringe benefits, and similar items;
2. Gross income derived from business;
3. Gains derived from dealings in property;
4. Interest;
5. Rents;
6. Royalties;
7. Dividends;
8. Alimony and separate maintenance payments;
9. Annuities;
10. Income from life insurance and endowment contracts;
11. Pensions;
12. Income from discharge of indebtedness;
13. Distributive share of partnership gross income;
14. Income in respect of a decedent; and
15. Income from an interest in an estate or trust."

It is important that we pay attention to the “but not limited to” portion of that definition. Although the definition covers many different types of income, we must also consider what the Minister Audit Technique Guide says. This acknowledges that in addition to a “normal salary”, a minister may also receive bonuses or “special gifts.” It goes on to state that the “minister may receive fees paid directly from parishioners for performing weddings, funerals, baptisms, masses and other contributions received for services”, and that all would be included in gross income under Treasury Regulation § 1.61-2(a)(1), “along with expense allowances for travel, transportation, or other business expenses received under a non-accountable plan.” Therefore, it is critical that we begin to broaden our own definition of what encompasses ministerial compensation. To preserve clarity on this subject, let us next examine a common misunderstanding that many ministers have regarding their income.

Misconception corrected

Perhaps one of the most common misunderstandings we hear from ministers around tax season is, “Well, I’m not required to pay income tax on my earnings as a minister.” Although that would be nice, that is simply not true. This line of thinking usually stems from Publication 1828, which states,
“Unlike other exempt organizations or businesses, a church is not required to withhold income tax from the compensation that it pays to its duly ordained, commissioned, or licensed ministers for performing services in the exercise of their ministry.”
It is easy to misunderstand or misconstrue what this is saying, but this is simply exempting the church, as the employer, from having to withhold taxes from the compensation it pays its minister(s). This is not exempting the minister from having to pay income tax, but rather the responsibility of withholding and paying income tax falls upon the minister. Because of this common misunderstanding, some ministers will find that they owe income tax to the IRS when they file their personal tax return.
Now, yes, if a minister strategically establishes his/her compensation by implementing a compliant housing allowance and opting out of self-employment tax, then he/she may pay little to no taxes on the income he or she receives as a minister. If you would like more information regarding these two tax privileges, please click on either link provided above, or give our office a call at 770-638-3444.

What does ministerial compensation encompass?

There are many different words that can be used to describe the compensation given to ministers. Some examples may include, but are not limited to, love offerings, honorariums, stipends, salary, housing allowance, cash gifts, and much more. The necessity here is to note that all of these are considered forms of compensation that must be considered for tax purposes and reported on one’s personal income tax return.
You may also be wondering about gifts that the church gives to the pastor throughout the year, such as gift cards. Unfortunately, these are also considered taxable income. Treasury regulation section 1.132-6(c) makes it clear that cash or cash equivalents are subject to federal income tax as well as Social Security tax. Many churches are completely unaware of this all important fact. For more information on the particular topic of gifts, I want to encourage you to read my blog “IRS Says Turkey or Ham OK for Churches”.

Know which step to take next

Now, the first step in understanding your ministerial compensation is knowing what is considered taxable income, which we discussed in this post. The second step in understanding your compensation is knowing how to properly determine reasonable compensation, which we will discuss in part two of this series later in the week.
As a pastor, I understand the importance of determining an appropriate salary that is not only affordable to the church, but also reasonable compensation to the pastor. It is for this reason that we offer a Minister’s Compensation Package service. Perhaps you already have a compensation package in place with your church; but understanding the importance and intricacies of a compensation contract can sometimes be difficult and overwhelming. We are here to help you!
If you (or your board) have any questions about establishing proper ministerial compensations, call our office today and let us help better your understanding.  Also, make plans to join us at one of our Ultimate Church Structure Conferences, where we discuss in detail each of the strategies that you need to know in order to properly handle your finances and taxes as a minister.