7 RECURRING MISTAKES WITH MINISTERIAL TAX RETURNS
By Trey Lewis
It most likely comes as no surprise that taxes can be daunting. Since the process, and even the idea, of doing our taxes is daunting, we typically pay someone else to do them for us. Taxes can especially be intimidating for ministers because if churches do not properly handle the ministers’ compensation and taxes, then ministers can end up paying more taxes than the average taxpayer.
I realize that may come as a surprise to many of you, but it is true. From our years of experience in helping ministers file their income taxes, we have seen compensation and tax mistakes made by both the churches and the pastors on the front end, and as a consequence, the pastors ended up paying for it dearly on the back end.
7 recurring mistakes with ministerial tax returns
Mistake #1: Faulty and incomplete housing allowance deduction claims.
A housing allowance is arguably the #1 tax benefit available to ministers. However, as a minister, how you establish and handle your housing allowance can make a significant difference in whether or not you maximize this tax benefit.
Ministers are often under the impression that they can claim as a housing allowance whatever was initially approved by their board of directors. Yet, according to the IRS, the amount that you are allowed to claim as a housing allowance is the lesser of the following:
The fair market rental value of your home.
The actual cost of providing and living in your home.
The amount approved by your board of directors.
Since your housing allowance deduction is based on the lesser of the three factors, it is important and necessary that you maintain and keep track of all of your housing expenses for the year. Not tracking these expenses may lead to a minister claiming more of a housing allowance than what he/she can claim.
We recommend and teach that one of the strategies to maximize your housing allowance benefit is for your board of directors to approve your housing allowance at up to 100% of your income. This does not necessarily mean your housing allowance will be 100% of your income, but rather, this helps to ensure that you are not “leaving any money on the table” so to speak.
Mistake #2: Failure to pay social security tax on the designated housing allowance.
The housing allowance is arguably the best tax benefit afforded to ministers, but at the same time, there is a large disconnect amongst churches and pastors as to how the housing allowance benefit actually works.
You may have heard that your designated housing allowance is exempt from income tax, and, yes, that is true. However, if you, as a minister, have not “opted-out” of having to withhold and pay the 15.3% social security tax, then your designated housing allowance is still subject to the 15.3% social security tax. (You may have also heard the social security tax referred to as the self-employment tax.)
Let us look at an example.
Minister X earns an annual salary of $40,000.00 from his church and $20,000.00 of his annual salary is designated as a housing allowance. From this we know that $20,000.00 of his annual salary of $40,000.00 is exempt from income tax since it has been approved as a housing allowance. However, Minister X has not taken the proper steps to “opt-out” of paying the social security tax. Therefore, Minister X must withhold and pay the 15.3% social security tax on his full salary amount of $40,000.00, which would be $6,120.00.
Important note: If you have filed Form 4361 with the IRS to “opt-out” of paying the social security tax and your approval is still pending, then you must still pay the 15.3% tax. Once your approval comes through, then you may amend your tax return and get that money back from the IRS.
Mistake #3: Misunderstanding of the home office deduction.
Do you have a home office that you use for church purposes? Perhaps it is a spare bedroom that you have converted into an office, or maybe it is simply a table or desk in the corner of the dining room. Regardless, your home office can be used as a tax deduction, however, there are certain requirements that you must meet in order to utilize this benefit.
Many ministers have heard of the home office deduction, but there is a misunderstanding of how it actually applies to their situation. According to Internal Revenue Code §280A and IRS Publication 587, in order for you to be eligible for the home office deduction, there are four requirements that you must meet.
We discuss these four requirements in a previous blog post, but I will list and summarize them below.
- Exclusive use: The area of the home must be used only for trade or business. It cannot be used for any other purpose.
- Regular basis: The specific area of your home must be used on a regular basis for business use.
- Convenience of the employer: This means that the home office must do more than make the employee’s job easier. The employee’s home office must be essential to the performance of his/her job.
- Principle place of business: The home must be the principle place of business. Furthermore, the home will qualify as the principle place of business if there is no other fixed location where administrative tasks are substantially conducted.
Mistake #4: Attempting to file two income tax returns.
It is not uncommon for ministers of smaller churches or new church plants to be bivocational. To help make ends meet for their families, many ministers will seek and maintain secular employment until their churches grow and are able to pay them a more substantial full-time salary. This bivocational status, receiving some compensation from the church and some from an outside place of employment, can lead to some confusion during tax season.
Due to the nuances associated with ministerial compensation and taxes, it is easy to see why some ministers believe they need to file two income tax returns. However, if you receive two Form W-2s, one from the church and another from a different employer, it does not mean that you need to file two tax returns.
In short, you should only file one tax return for each tax year, no matter how many sources of income you have.
Mistake #5: Spouses attempting to file two tax returns as head of household.
How you choose to file your taxes matters. This is especially so if you and your spouse work and need to file taxes. In general, if you are married, then you and your spouse will either choose to file individual tax returns or choose to file a joint tax return.
If you decide to file separate tax returns, then it is important to know that only one of you can claim head of household. In addition, if you have children, then only one of you will be able to claim them as dependents and receive the child tax credit.
It is imperative to know that filing two tax returns per family in an effort to get additional tax benefits is a fraudulent act. If caught by the IRS, the taxpayers may be convicted of fraud and incur penalties and prosecution.
Mistake #6: Your child in college files his/her own tax return without your knowledge.
If you have children in college, then this is something to be mindful of. We have seen ministers surprised to learn that a child in college filed an advance tax return claiming his/her self. When this occurs (without your knowledge) your exemptions become incorrect and other problems arise, such as your tax return is rejected because your child filed his/her own tax return in order to get a refund for spring break.
Therefore, if you have children in college and you plan on claiming them as dependents, then it would be wise to have a conversation with them to make sure they have not filed their own tax return.
Mistake #7: Neglecting a 1099 from a brokerage firm.
Many people have investments in stocks, bonds, and other various investment accounts. Depending on the type of investment, you may receive a 1099 in the mail from that brokerage firm or investment group. It is important to make sure that you do not neglect to provide your tax professional with the 1099 from a brokerage firm, even if you did not make any money on your stock trading account. If you have trades, the IRS assumes 100% profit unless you show the transactions on schedule D and reflect the basis of the stocks.