Compensation for performance of religious duties by an ordained, commissioned or licensed minister is treated as employee wages for income tax purposes, and as self-employment (SE) income for employment (FICA) tax purposes.
Certain church employees of organizations with an exemption from Social Security and Medicare taxes are also subject to this dual-status treatment. Wages earned by most church employees and unordained ministers are generally reported in the same manner as any other employee.
A Form W-2 issued to a minister should contain the same information as any Form W-2, except the boxes for Social Security and Medicare will be blank. Wages from box 1 of Form W-2 are reported as taxable income on line 7 of Form 1040. The income is subject to SE tax and must be reported on Schedule SE, unless an exemption has been granted by the IRS.
Income and expenses for services not performed as an employee, such as honoraria from baptisms, weddings, funerals, etc., are reported on Schedule C (and Schedule SE).
To calculate SE income, add income related to ministerial activity, such as Form W-2 wages, Schedule C income, and housing/parsonage and auto allowances, then subtract business expenses from Form 2106 or Schedule C. The result is reported as SE income on Schedule SE. Attach a statement if SE earnings are reduced by expenses claimed on Form 2106.
A church may provide housing to clergy, or pay a parsonage allowance as compensation for services. An ordained, commissioned or licensed minister may exclude from gross income the rental value of the housing or the amount of parsonage allowance (IRC §107). The excluded amount is not subject to income tax, but must be reported as SE income on Schedule SE. [IRC §1402(a)(8))
To qualify, the church must include in its minutes a breakdown of the pay package, including a specified amount of parsonage allowance, before the payment is made. The exclusion cannot exceed reasonable pay for services. If the minister owns the home, the exclusion cannot exceed amounts actually used to keep up the home.
Exclusion limited to:
- The rental value of a home furnished to the minister or
- An allowance paid to the minister to the extent it is used to provide or rent a home and to the extent the allowance does not exceed the fair rental value of the home (including furnishings) plus the cost of utilities.
The housing or parsonage allowance should not be included as taxable wages in box 1 of Form W-2, but may (not required) be shown in box 14.
Retired ministers (but not surviving spouses) are allowed an income exclusion for:
- Fair rental value of a home provided as payment for past services or
- The part of a pension that is designated as a housing allowance.
The exclusion from income for retired ministers applies for both income tax and SE tax. [IRC §1402(a)(8)]
Note: A 2013 district court case in which the court held that the parsonage allowance income exclusion is unconstitutional was later vacated by the appellate court and remanded to the district court with instructions to dismiss the complaint because the plaintiff did not have standing to challenge the constitutionality of the provision. [Freedom From Religion Foundation, Inc. v. Lew, 114 AFTR 2d 2014-6570 (7th Cir. 2014)]
Expenses Allocable to Tax-Exempt Income
Any expense allocable to tax-exempt income may not be deducted [IRC §265(a)(1)]. Ministers may not deduct unreimbursed business expenses to the extent allocable to tax-exempt income (for example, parsonage allowance). [Deason, 41 TC 465 (1964)]
Example: Reverend Baker's salary of $40,000 includes a $10,000 parsonage/ housing allowance, so 25% ($10,000 divided by $40,000) of his salary is tax exempt. He has $3,000 of unreimbursed business expenses. Therefore, only 75% of the $3,000 ($2,500) is deductible, subject to the 2% floor, if the minister has sufficient other deductions to itemized his deductions. If the minister cannot itemize all of his deductions, the minister would lose the ministry expenses as a deduction.
Exception: [Deason, 41 TC 465 (1964)] Mortgage interest and taxes paid on a home are allowable as itemized deductions even if paid by an excluded parsonage allowance [IRC §265(a)(6)]. Home equity loan interest must be used for financing the parsonage to be deductible under this provision. (Ramussen, TC Memo 1994-311)
When expenses must be allocated between taxable and nontaxable income, attach a statement containing the following information to the return. (Pub. 517)
- List of taxable ministerial income items and amounts.
- List of nontaxable ministerial income (parsonage allowance) and amounts.
- List of otherwise deductible ministerial expenses and amounts.
- How the nondeductible part of the expenses was computed.
- Statement that other deductions claimed on the return are not allocable to tax-free income.
FICA and SE Tax Exemptions
Ministers, Christian Science practitioners, members of religious orders and members of recognized religious sects who are conscientiously opposed to public insurance because of their individual religious considerations (not because of their general conscience), or are opposed because of the principles of their religious denomination may apply for exemption from SE tax. The exemption applies only to income from services performed in the exercise of the taxpayer's ministry or as required by his religious order. The following forms are filed to apply for exemption (see IRS Publication 517 for more information):
- Form 4029, Application for Exemption From Social Security and Medicare Taxes and Waiver of Benefits. [Reg. §1.1402(c)-7]
- Form 4361, Application for Exemption From Self-Employment Tax for Use by Ministers, Members of Religious Orders and Christian Science Practitioners. [Reg. §1.1402(e)-1A through -5A]
Amounts given to a minister by a church as a gift or holiday bonus are additional wages. Amounts received from the members of the church as fees for services performed are SE income. Gifts (donor does not expect to receive anything in return or has not received anything in return) from individual members are not included in income.
Earned Income Credit (EIC)
Earned income for the EIC includes employee compensation such as wages, salaries, tips, etc., and net earnings from self-employment reported on Schedule SE (less the deduction for SE tax).
A parsonage allowance is not reported as taxable wages, but is reported as SE income and is considered earned income for EIC purposes. Exception: See SE tax exemption below.
Ministers and Church Employees
Ministers (and church employees exempt from FICA) who report earnings on Schedule C or on Schedule SE use Worksheet B—Earned Income Credit to compute their earned income for the EIC. Because of their "dual status" (employee for income tax, self-employed for SE tax) these individuals may also have income reported on line 7 (Wages) of their Form 1040. This income is not double counted for the EIC because wages reported on Form 1040, line 7 by a minister or church employee are reduced by any amount also reported on Schedule SE to compute the amount on line 7 that is earned income for the EIC.
Members of the clergy should print "Clergy" on the dotted line next to line 66a of Form 1040.
SE Tax Exemption
Individuals who have been granted an exemption from SE tax use the following rules to determine earned income for the EIC.
- Form 4029. For members of recognized religious groups who have an approved Form 4029, wages and other taxable employee compensation are earned income. Do not include amounts received as a self-employed individual (and do not subtract losses on Schedule C from wages on line 7 of Form 1040).
- Form 4361. Ministers who have an approved Form 4361 include amounts received for performing ministerial duties as an employee (including wages and other taxable employee compensation). A nontaxable parsonage allowance is not earned income. Amounts received for performing non-employee ministerial duties (such as fees for performing marriages and honoraria for delivering speeches) are not earned income. Any net self-employment earnings (minus deductible portion of SE tax) or wages received for non-ministerial duties are earned income.
Qualified Plan and IRA Contributions
Compensation, for purposes of qualified retirement plans and IRAs, includes net income that is not subject to SE tax because of a religious exemption. This allows ministers with SE income that are exempt from SE tax based on religious grounds to establish and contribute to a profit-sharing plan, SEP, SIMPLE or IRA.
Note: Ministers who are not exempt from the SE tax use the income from Schedule SE plus all other employment income to calculate their allowable retirement plan contribution.
Exception: Nontaxable income (such as a parsonage allowance) is not considered compensation for either an employer or self-employed retirement plan, even though the amount is subject to SE tax on Schedule SE. (Ltr. Rul. 200135045)