Ministers who are conscientiously opposed to, or because of their religious principles are opposed to, the acceptance of any public insurance (such as Social Security or Medicare) with respect to their ministerial earnings may elect out of the Social Security and Medicare system by filing Form 4361 with the IRS.
Form 4361 generally must be filed within two years of the first year that a minister has earnings from ministerial work. Ministers who have made this election would not complete Schedule SE but would indicate exemption by checking the box for 4361 on Form 1040, Schedule 2, line 4, and/or entering “Exempt-Form 4361” on the dotted line next to Form 1040, line 23 (other taxes, including self-employment tax).
Tip: Learn more about the dual tax status of ministers and six questions to address before pursuing exemption from the Social Security and Medicare system.
Ministers using tax preparation software should check to make sure that the software accepts their Form W-2, since a properly prepared Form W-2 will not show their wages as subject to Social Security or Medicare taxes.
Ministers also should make sure that their wages are being treated by the software package as self-employment income, for purposes of computing the self-employment tax, if applicable to the minister.
For ministers opting out of the Social Security and Medicare system, check to make sure that the tax software package makes the notational entry on Schedule 2, line 4, and/or line 23 of the Form 1040.
2. Parsonage or Housing Allowance Exclusion
Ministers may exclude from their taxable income the annual fair rental value of a parsonage provided rent-free by their church as part of their compensation package.
Ministers living in their own homes may exclude from their taxable income cash payments that have been properly designated by their employing church as a ministerial housing allowance, up to the lesser of (1) the amount used to pay for housing-related expenses (such as mortgage payments or rent, utilities, repairs, furnishings, insurance, property taxes, improvements, maintenance, and homeowners’ association dues), or (2) the fair rental value of the home, including furnishings and utilities.
The excess of the amount designated over the excludable amount should be included in taxable income (and the words “Excess Allowance” should be added on the dotted line next to the appropriate Form 1040, Line 1h).
The allowance is excludable for income tax purposes only. For ministers who have not opted out of the Social Security and Medicare system, their parsonage/housing allowance must generally be included in determining their self-employment tax.
Therefore, ministers using tax preparation software should check to make sure the package is properly limiting the housing allowance exclusion based on the limitations noted above, including the ”Excess Allowance” notation, and that the package is properly including the parsonage/housing allowance amount in the calculation of self-employment income.
RELATED: Guide To Amending a Pastor’s Housing Allowance
3. Limitation on—Or Disallowance Of—Business Expense Deductions
Many ministers incur unreimbursed expenses in connection with their church employment. Generally, such unreimbursed employee business expenses are not deductible for federal income tax purposes. (However, such expenses are still deductible for self-employment tax purposes.)
Ministers might also incur expenses, such as travel expenses, in connection with ministerial income earned outside of their employment (such as honorarium payments received for speaking engagements, weddings, or funerals). Business expenses related to ministerial income earned outside of a minister’s employment (reportable on Form 1040, Schedule C) incurred in connection with ministerial earnings are not deductible for federal income tax purposes to the extent that they are allocable to tax-exempt parsonage or housing allowances.
To compute the nondeductible portion, the minister should first determine his total ministerial income, including the parsonage/housing allowance. The minister should then divide the parsonage/housing allowance by the total ministerial income to determine the nontaxable percentage. This percentage should then be applied to any business expenses incurred to determine the nondeductible portion. Only the deductible portion should then be reported on Schedule C.
For detailed tax guidance: Additional information is in Richard Hammar’s annual Church & Clergy Tax Guide. Chapter 13 of Hammar’s guide contains a sample minister’s tax return (prepared by Batts Morrison Wales & Lee, CPAs) illustrating the concepts described in this article. Ministers should also consider seeking the advice of a tax professional with experience in preparing ministers’ tax returns.
Many tax software packages do not automatically calculate the nondeductible portion of business expenses allocable to the tax-free portion of a minister’s income. Ministers will therefore need to manually adjust these expenses and input the reduced figure into the software for purposes of computing the income tax deduction. However, since the parsonage/housing allowance is included in the computation of the amount subject to the self-employment tax, the full amount of the business expenses should be used to compute the net earnings from self-employment reportable on Schedule SE.
Consider a Professional Tax Preparer Review
Because these unique rules are so critical to filing accurate and mistake-free returns, ministers who opt to use tax preparation software may wish to have returns reviewed by a tax professional with experience in preparing ministers’ returns.
