Ministers are allowed certain tax breaks. One of the most important of these is a minister’s ability to avoid taxation on some or all of his ministerial income that is designated by his church as a housing allowance. However, as explained below, while ministers may avoid paying tax on their housing allowance, they must pay self-employment tax on it.
Generally speaking, a minister’s income (from his ministry-related services) is considered income from self-employment, and is thus subject to the self-employment tax rules. The self-employment tax—otherwise called the Self-Employment Contributions Act (SECA) tax—is what a self-employed person pays rather than Federal Insurance Contributions Act (FICA) tax paid by employees. FICA tax is designed to fund Social Security and Medicare.
A self-employed person often pays more in tax than an employee. This is because the FICA tax is actually split between an employer and an employee; thus, they share the costs of Social Security and Medicare. By contrast, a self-employed person must bear the full costs of paying for his or her share for Social Security and Medicare (i.e. without the help of an employer).
Ministers may avoid paying tax on their housing allowance that is designated by the church, but they must pay self-employment tax on it. Practically, what this means is that a minister might have one figure for his “gross income” (to determine his taxable income for Federal income tax purposes) and a different, higher figure for self-employment tax purposes. This “incongruity” also means that a minister can be deemed an “employee” for income tax purposes, even thought certain payments he receives are deemed income from self employment for social security and medical taxes. In sum, he may technically be both “self-employed” and an “employee” (though for different tax purposes).
The IRS’s Ministers Audit Techniques Guide suggests that auditors discern whether the minister failed to report his housing allowance as an item of income for SECA purposes. Housing allowance income is exempt tax under IRC § 107, but it is still subject to self-employment tax under SECA and IRC §1402(a)(8). The IRS wants to make sure this is properly reflected in a minister’s tax return.
There are certain exceptions, however. That is, there are instances when a minster’s housing allowance is not subject to SECA tax. The IRS’s Ministers Audit Techniques Guide outlines three exceptions found in IRC § 1402(e):
(1) the minister is a member of a religious order whose members have taken a vow of poverty;
(2) the minister requested, and the IRS approved, an exemption from self-employment tax (there are several requirements to obtain this approval); or
(3) the minister is subject only to the social security laws of a foreign country.
The first exception—the vow of poverty exception—is rather unique. A minister who is a member of a religious order that has taken a vow of poverty is exempt from income tax and self-employment tax on the earnings he provides as the “agent” of the church.
But what if the minister is providing services that fall outside that particular church’s functions? That is, what if he is not acting as an agent of the church or order, but is instead performing religious work in his individual capacity—and receives compensation for it? Under Rev. Rul. 76-323, the minister must include that his gross income (pay Federal income tax)—and they are wages subject to FICA and income tax withholdings. The minister could, of course, simply donate his remuneration—and take a charitable deduction.
Whether the minister is deemed an agent of the church (or is deemed to act within his individual capacity) will depend upon the “general rules of agency to be established by considering all the underlying facts.” Fogarty v. U.S., 780 F.2d 1005, 1012 (Fed. Cir. 1986). The Fogarty court considers six factors in making the agency determination: (1) the degree of control the church exercises over the minister; (2) the presence of any ownership rights between the minister and the church/order); (3) the purpose of the particular order or church; (4) the type of work the minister perform in light of the order’s mission; (5) the dealings between the minister and the third-party employer; and (6) any dealings between the employer and the church/order.
These six factors are designed to create flexibility in the agency relationship—so that one may be found more readily. However, sometimes no agency relationship is found—and the minister’s income is subject to tax.
For example, in Rev. Rul. 79-132, a military chaplain was a member of a religious order that took a vow of poverty. He received income for his services, but the minister simply turned over the income to the order (the church). The IRS ruled that the minister was required to include the amount he received in his gross income (subject to tax), notwithstanding the fact that the minister (effectively) disclaimed the amount to the church. However, the Ruling clarified that “individual members are entitled to charitable contribution deductions under IRC § 170 for amounts donated to the order.”