Filing Taxes for Clerics by Chapter and Verse

By Raymond M. Nowicki

A rabbi and a priest walk into a CPA firm on April 14. The rabbi says to the CPA…”

What sounds like the set-up of a bad Henny Youngman joke is really an introduction to a realm of tax regulation shrouded in mystery for too many people and in need of reform.

This past season, many practitioners encountered members of the clergy requesting tax services. A CPA may have waived his fees out of kindness to a religious leader, and in the hope of a rewarding spiritual experience. A CPA may have even thought, “This person doesn’t make much money, how difficult can their return be?” Or, worse yet, “How bad is the tax exposure?” a potential violation of Internal Revenue Service (IRS) Circular 230.

Hours of non-billable time later, the CPA rubbed his temples, recalling the famous adage: the road to hell is paved with good intentions.

A Thorn in Your Side

A cleric’s return can be fraught with some strange tax twists.

He may have multistate or international filing concerns, because of shared duty at different posts. His gross income may come from several sources: a church salary, expense reimbursements, parsonage allowances, service stipends from weddings, funerals and bar mitzvahs, or even outside service income. A portion of the cleric’s revenue stream may be cash, and the question occurs to the taxpayer, “Is it reportable?” The taxpayer may use a technical argument to justify that cash offerings are a “nontaxable gift,” instead of a “fee for service.”

Furthermore, the CPA must consider whether the cleric is an employee or an independent contractor; if his income is subject to self-employment (SE) tax and income tax in the same manner; if the cleric answers to a higher authority (canon law) or if he takes a vow of poverty.

A CPA must ask: Are business expenses deductible on Form 2106 or Schedule C? Will tax software easily accommodate the twists in the clergy’s return? Is the CPA dealing with a client who has “business sense,” or an understanding of the importance and risks associated with filing an accurate return? Is the cleric an audit target because of other pending investigations? Don’t forget that Sun Myung Moon, Jim and Tammy Faye Baker and Sheik Omar Abdul Rachman were religious clerics.

Four Steps to Nirvana

Keeping these issues in mind, consider this four-step primer for accepting and completing a tax engagement for a member of the clergy.

Step 1: Assess your firm’s motives, commitment and capabilities. Gather facts about the engagement before you decide to accept it, taking into account the crucial elements listed below.

Consider the client. Members of the clergy are typically not well paid, and profit motive for your firm may not be a key reason to accept the client. Referrals from your new cleric-client may be a compensating motive, but don’t be shocked if your name is not praised from the pulpit, since most clerics still equate tax returns to oral surgery. My experience is that many members of the clergy are unsophisticated in financial affairs, making information-gathering more difficult. However, do not confuse the shortage of financial acumen with the inability to argue theoretically with you, since clerics are usually highly educated people. Some clerics may be unavailable at tax time, such as clerics who may be celebrating major religious seasons, like Easter or Passover, that fall around April 15.

Think about your capability. Your first return for a cleric requires a significant learning curve since it is governed by a substantial number of tax rules unique to the occupation, such as computation of self-employment earnings. You will need to familiarize yourself with IRS Publication 517. Another good source of reading is “Income Tax for Priests Only,” published by the National Federation of Priests’ Councils. A CPA also needs practical background knowledge about the client’s business. Expect to take extra time during the tax interview to gain a specific understanding of the work your client performs, his sources of income, and the reporting systems and tax elections of the church, synagogue, temple or mosque of the client. Especially in a first-year engagement, one could easily overlook revenues or expenses not evident from the documents presented by the client.

Question your commitment. Would your firm view such an engagement as “important”? Is your library adequate to address these issues? Is your tax software tailored to accommodate a cleric’s return? (You may be surprised to find that tax software produced by two major vendors did not have this flexibility, requiring substantial overrides to produce the desired result.) Finally, are you willing to do the return in accordance with professional standards, the Internal

Revenue Code and Treasury regulations? One may be unduly influenced by the impoverished or austere earnings of a cleric, or embarrassed to question a religious leader’s lifestyle. Yet, those questions may be necessary to achieve a complete and accurate return while taking advantage of all appropriate deductions. Ask yourself before the tax interview if you really want this work and why.

Step 2: Determining coverage under SE or FICA.

Is your client self-employed, an employee, or exempt from FICA and self-employment tax? Publication 517 states that Catholic priests are considered self-employed for Social Security tax purposes, but employees for income tax purposes. Generally, self-employment is based on a facts and circumstances test. Your client will be considered an employee if the employer has the legal right to control his work as a cleric, even though the cleric may exercise considerable discretion and freedom. Employment by a congregation for a salary generally will subject the cleric to treatment as an employee for income tax purposes.

For FICA and SE tax purposes, a church and qualified church-controlled organization that is opposed for religious reasons to Social Security and Medicare can elect to exclude their cleric from FICA. In this instance, a cleric who is paid $108.28 or more in wages must pay SE tax on his earnings.

If the cleric is a member of a religious order and has taken a vow of poverty, he is exempt from SE tax on qualified services, provided an exemption is requested from the IRS using Form 4361. Qualified services include the performance of sacerdotal functions, conducting religious worship, or controlling, conducting and maintaining religious organizations that are under the authority of the church—a term used here generically for all faiths. If a member of a religious order is directed to work outside the order, as an agent of the order, those earnings can be exempt as well. However, in order for outside employment to qualify, it must meet both standards of a two-pronged test: the services are the type ordinarily performed by the order, and the services are part of the duties that must be exercised for or on behalf of the religious order, as its agent.

A tax practitioner easily could misunderstand the application of the SE and FICA rules for the cleric because the cleric may not be able to explain the rule to which he is subject. This situation will require the tax practitioner to expand the scope of his work, so as to avoid an improperly filed return.

In general, the presentation of a W-2 form with FICA withheld for the cleric will be the basis for reporting that gross income as wages for computation of the SE tax. A church that has filed for an exemption from the Social Security tax usually will provide the cleric with a W-2 showing no FICA withheld. In this instance, the cleric must treat the earnings as being subject to SE tax.

Gross income from self-employment also will include: offerings received for performing rites like weddings or funerals; the value of meals and lodging provided to the cleric, spouse and dependents for the employer’s convenience; the fair rental value of a parsonage, including the cost of utilities; and amounts paid by the church to indemnify the cleric for taxes.

The value of meals and lodging and the rental of a parsonage usually will not be included in the W-2. Therefore, the tax practitioner may need to compute fair value of such items, considering all of the variables associated with the parsonage. In this regard, there is some latitude on the amount declared as gross SE income, and the tax preparer may need to reconstruct this data for lack of actual records.
Net earnings from self-employment are determined without the benefit of the foreign earned income exclusion.

The practitioner should not include, in the determination of SE gross income: offerings made directly to the church, the rental value of a parsonage for a retired cleric, or pension payments.

My experience is that the SE tax is the most onerous of taxes on clerics, from the standpoint of cost and computation. The cleric may not have kept a record of offerings for services. In this instance, the record may easily be reconstructed by reference to documents such as weekly parish bulletins or calendars, which identify services offered as memorials or special celebrations. Inquire of the cleric whether there is a general standard offering, and examine the bulletin with the cleric to estimate the offerings received. Be careful to note references to funerals or wedding services, which may not have a specific date indicated in the bulletin.

A cleric may argue that an offering is not taxable because it is a gift, and not a fee for his services. In one instance, a cleric explained that he would offer Mass for parishioners even if they could not afford a stipend. Treasury regulations Section 1.61-2(a) indicates that such fees are taxable for income and SE purposes. This is supported by a variety of court cases, including Goodwin v. USA (docket no. 94-3796; Oct. 4, 1995). In A.G. Bogardus v. Comm., the court held that a gift is compensation if it is made in recognition of services in the fulfillment of a moral or legal duty, or in the anticipation of economic gain.

When a cleric receives compensation, he may turn the payments over to the church as may be required by his vow of poverty with his religious order, or based upon an agreement with his church. However, there have been cases where a cleric exercised full dominion and control over outside earnings, even though a cleric takes a vow of poverty. The end result could be a disastrous one, subjecting the cleric to SE tax, and only allowing him a charitable deduction for income tax purposes. It is advisable to review Publication 526, in such an instance.

Allowable deductions against SE income associated with clerical acts generally will include all normal business deductions. However, the tax practitioner needs to delve into the services rendered by the cleric to identify unique costs, such as vestments (uniforms), religious artifacts, books and ministerial journals, gifts to congregational members who support the cleric’s efforts, the costs of ministerial retreats, and costs to support group activities. Do not report expenses as deductions from gross SE income if the expenses were reimbursed under an accountable reimbursement plan.

Step 3: Computing income tax.

A tax professional will have substantially all of the components needed to compute the income tax, using normal and customary methods once the SE tax issue is addressed. However, there are several differences between the SE tax and the income tax treatment.
A cleric may be able to exclude the fair rental value of a parsonage from the computation of gross income for income tax purposes. However, if the cleric has received a rental or utility allowance and has not spent it all on rent or a home, it should be included for income tax purposes.

Tax deductions related to the cleric’s ministry must be allocated between the various sources of gross income. For instance, the parsonage allowance is tax free, the salary from the congregation is wages, and stipends are self-employment income. Therefore, expenses need to be reflected in the return as they relate to these three different types of sources.

Ministerial expenses associated with employment are reported on Form 2106, as a miscellaneous itemized deduction. The cleric therefore will lose the benefit of some portion of this deduction, if he does not itemize, and will be subject to the two percent disallowance rule. Mortgage interest and real estate taxes that are reimbursed through an income-tax-free parsonage allowance must be treated as nondeductible using an allocation percentage of tax-free parsonage or rental allowance divided by all income earned. Publication 517 gives several examples of this calculation. However, the examples do not appear to consider other resources available to pay for mortgage interest and real estate taxes of the cleric’s parsonage, such as investment income and inheritances.

The tax treatment of medical insurance, retirement plan deductions and estimated tax rules generally follows the same rules for self-employed ministers as for regular tax filers.

Step 4: Examining your conscience.

The tax practitioner may encounter some unique aspects to dealing with a cleric’s tax return. Clerics typically spend substantial time on their ministerial duties, neglecting the business of their ministry. This makes documentation and record reconstruction a time-consuming process. Meanwhile, the aura of a religious person may cloud a CPA’s professional skepticism, causing the tax professional to be less forthright in making inquiries. Keep in mind that, as my grandfather once told me, “A priest is a priest behind the altar; after that, he is just like you and me.” This might help the practitioner put the engagement in its proper perspective.

Do not assume the IRS or other government authorities are not interested in clerics who do not comply with civil law. Of the religious leaders mentioned above, Baker was convicted of fraud, Rachman was imprisoned for coordinating the 1993 World Trade Center bombing, and Moon was investigated by a House subcommittee for abuse of his church’s tax-exempt status.

There is precedent for the coordinated targeting by the IRS of groups of clerics in situations where there was evidence of widespread noncompliance with the rules, irregardless of the intent. In light of the current investigations of certain clerics on other matters, it is quite possible that legal authorities may be reviewing tax returns, charge accounts, bank accounts and other fincancial records of those clerics under scrutiny.

One easily could be duped into thinking that a cleric’s tax return is a simple matter, because of the limited income and austere lifestyle he or she often portrays. It seems unfortunate that many good religious leaders are subjected to such onerous tax reporting rules. It is the duty of the tax professional to be cognizant of those rules and employ them properly in the return. Tax advice was evenly dispensed in the New Testament, some 2000 years ago. You may recognize the quote: “Render unto Caesar, that which is Caesar’s.”