4 Steps to Payroll Compliance
By Raul Rivera
Pastor Jenkins has always been the type of person to do things “by the books”. Growing up in a military family, it was only natural that he grew up in a family that was strict and orderly, but it was also full of love. His parents were devout followers of Christ, and it was during his adolescent years that he learned to love the Lord, as well as his country.
After graduating high school, he decided to spend four years in the United States Navy in order to keep the tradition his father and grandfather had established. It was during this time that he first felt the Lord calling him into the ministry.
Once he completed his service in the Navy, Pastor Jenkins knew that his calling was to be a pastor, but he first decided to pursue a bachelor’s degree in business. His reasoning for first pursuing his degree, before diving head first into ministry, was simple: 1) to take advantage of the free education paid for by the government for his service in the Navy; and 2) because he thought that having a business degree would help him to begin and operate a church in an administrative sense.
More than what meets the eye
After completing his degree and receiving a blessing from his pastor to start a church, Pastor Jenkins and his wife moved to Charlottesville, Virginia to plant the church that God had first laid on his heart 6 years earlier. Although he knew that planting a church would have its challenges, he was confident in the administrative skills that he would get to utilize.
After 12 years, everything seemed to be going well for the church; both spiritually and administratively. The church was now averaging between 500 - 600 members each Sunday, they had a successful children's and youth program, and they even had an outreach ministry that was helping to feed approximately 400 needy families per month. On an administrative level, there was plenty of surplus in the church’s checking account, they had a “healthy” savings account, and the church had a total of 6 full-time employees and 2 part-time employees. Everything seemed to be working like clockwork.
However, after attending one of our conferences, Pastor Jenkins realized that some administrative aspects he was taught in business school did not work quite the same for a church. The way the church had set up its payroll was incorrect, and he knew he needed to make a change.
Church payroll
When a church hires a worker, one of the initial decisions that must be made is whether to treat the worker as a contract worker or as an employee. This decision may seem insignificant, but it has huge implications when it comes to payroll.
Many churches are unaware that section 3121(b)(8)(A) prohibits the church from withholding Social Security and Medicare tax on the wages earned by a minister. It is the responsibility of the minister to pay the 15.3% self-employment tax on his/her salary and housing allowance unless he/she has applied for self-employment tax exemption. Additionally, ministers are exempt from income tax withholding. It is important to note that this does not mean that ministers are exempt from having to pay income tax; rather, the church does not have to withhold income tax from his/her pay. However, according to IRS Publication 517, a minister “can enter into a voluntary withholding agreement with the church to cover any income and self-employment tax that may be due.”
This is perhaps the one area that can cause a church the most “hiccups” when it comes to church payroll. To help further your understanding, let us look at the unique status of ministers.
The unique status of ministers
In order to understand the unique status of ministers, you must first understand how the IRS classifies an employee vs. self-employed individual (contract worker). Once that is understood, you will be able to comprehend the dual tax status of ministers.
Employee vs. contract worker
Oftentimes, when a church hires a worker, one of the most important, initial decisions the church must make is whether to treat the worker as an employee or contract worker. Many churches mistakenly believe that this decision is up to their discretion, when in reality the federal government uses common-law rules to determine whether a worker is an employee or contract worker.
IRS Publication 15-A states,
“Under common-law rules, anyone who performs services for you is generally your employee if you have the right to control what will be done and how it will be done. This is so even when you give the employee freedom of action. What matters is that you have the right to control the details of how the services are performed.”Common-law rules are composed of three factors: behavioral control, financial control, and the relationship of the parties. Following is a brief look at each.
- Behavioral control: Does the church have the ability to dictate how and when the person performs his/her duties? If so, the individual is an employee.
- Financial control: Does the church control the business aspects of the person’s job? Is the individual able to seek other job opportunities? If the worker is not permitted to seek other job opportunities then he/she is an employee of the church.
- Relationship of the parties: Does the individual provide duties/services that are vital to the church’s existence? If so, he/she is an employee.
The dual tax status of ministers
According to IRS Publication 517, most ministers have a dual tax status. What this means is that a minister is an employee of the church for federal income tax purposes and self-employed for Social Security purposes.
Oftentimes, churches treat their pastors as self-employed persons and assume that they can issue pastors a Form 1099-MISC. In actuality, since a minister is usually considered an employee under common-law rules, the minister should be treated as an employee for federal income tax purposes and should receive Form W-2 indicating the wages that the church paid to him/her.
When it comes to Social Security taxes, the minister is considered self-employed and is responsible to pay 100% of those taxes. Unlike the rest of the taxpaying population, when a minister completes his/her tax return, he/she is responsible for paying federal income tax and self-employment taxes. For instance, when a person works a secular job, the employer withholds federal income tax and Social Security tax. That simply is not the case for a minister because of his/her dual tax status. Therefore, a minister employed by your church should receive a Form W-2 indicating his/her wages earned from the church, and not a Form 1099-MISC.
Now that you understand how the IRS classifies an employee using common-law rules, and that ministers have a dual tax status, allow me to give you some recommendations pertaining to church payroll.
Church payroll recommendations
- Decide who handles payroll: Whether you choose to keep track of your own payroll or hire it out to a professional, the sooner you are able to do this, the better. If you decide to keep payroll an in-house responsibility then it is important that the church carefully calculate how much federal income tax to withhold and who will and will not need Social Security and Medicare tax withheld. If you hire a company to do your payroll then make sure that they understand the difference between ministers and regular employees.
- Have each employee complete a Form W-4: This form is used to gather the information necessary to withhold the correct amount of taxes. The IRS requires that the employer keep this form in the employer’s records at all times. Whether you have a minister (especially if he or she has entered into a voluntary withholding agreement) or a regular employee, this is an important and necessary step to take to ensure that the correct amount of tax is deducted. This form will not be submitted to the IRS.
- Choose a payroll frequency: Because every church is unique and will vary in preferences, it is important that your church choose whether it will run payroll weekly, bi-weekly, or monthly. We have found most churches that do their own payroll prefer a weekly pay schedule, and those who hire it out prefer a biweekly and sometimes monthly payroll.
- Know which informational returns to use: When it pertains to payroll, the church is required to file Form 941 each quarter. Those classified as employees will receive Form W-2 from the church, and contract workers that receive more than $600 in yearly earnings from the church will receive Form 1099-MISC. It is necessary that you receive Form W-9 from contract workers. The church will then need to submit to the IRS copies of all W-2 statements with Form W-3, and copies of all 1099-MISC statements with Form 1096.
Penalties for not withholding payroll taxes
Since the IRS spends significant time making sure that informational returns are filed correctly and on time, payroll tax obligations can be some of the most burdensome that churches face. The penalties for noncompliance can be stiff. For example, sections 6721 and 6722 provide penalties if the church does not file these forms on time and correctly. The penalties range from $30.00 per return to $100.00 per return, and if the IRS says the failure to file was willful, the penalty can be up to $250,000.00. In addition, if an organization has been found out of compliance in regards to withholding payroll taxes then according to section 6502, the IRS may look back into 10 years’ of payroll filings to make sure that they were filed correctly.
Conclusion
I am convinced that if you take time to work ON your ministry and not just IN the ministry, you can create a solid infrastructure from which you operate payroll and other administrative responsibilities of the church.
With that being said, I want to encourage you to consider utilizing our resources and services. If you are wanting more information pertaining to payroll then consider enrolling in our online church compliance course, StartCHURCH University. We have a whole unit consisting of four chapters dedicated to this very topic. Or perhaps, you want to learn how to correctly file W-2s and 1099s for your church. In that case, the W-2 and 1099 applet in our Management Suite will give you step-by-step instructions on how to e-file the informational returns for your church. And lastly, we would always love to have you join us for a day at one of our Ultimate Church Structure Conferences.