CPA's Advice Cost Church

By Raul Rivera

I met a pastor in San Diego, California a few years back at one of our conferences. He was attending the conference along with his church administrator. Upon learning that their church’s payroll might not have been done correctly, they approached me and asked if I would be willing to take a closer look at it.

After I had a brief understanding of their payroll, my response confirmed what they had feared, and it led to astonishment (and frankly, disbelief to a degree) of the situation because they had hired a local CPA to set up and handle their church’s payroll. 

Their question to me was, “How could the CPA get it wrong?” I responded, “It had to do with the fact that a minister has a dual tax status, which can cause much confusion.”

One of the most common mistakes churches make when it comes to payroll is the misclassification of a minister. Whether or not you are receiving compensation from your church as a pastor, this is a post that every pastor and church leader needs to read.

3 pastoral compensation mistakes

Later in this post I will share with you what happened with the church in San Diego, and I will address how you can determine a reasonable salary for pastors. However, before I do so, I want to give you the three most common mistakes churches make when paying their ministers a salary.

Mistake #1: Churches treat the minister as self-employed for tax purposes.

Many churches treat the pastor as a self-employed person and assume that they can issue the pastor a Form 1099-MISC. Whenever we talk with churches that operate in this manner we are usually told, “Well, that is the way we have always done things.” Or, I may hear, “That is how we were told to do it by another church that has been around for many years.”

The truth of the matter is that issuing your pastor a Form 1099-MISC is not correct and doing so can significantly raise the chances of his/her tax return being flagged for an audit.

You see, when a minister receives a Form 1099-MISC from the church, the minister will usually report his/her income on Schedule C and deduct unreimbursed expenses. This causes an incorrect tax return. 

In actuality, the minister should be treated as an employee for federal income tax purposes and should receive a Form W-2 showing the wages paid to the minister by the church.

Mistake #2: Churches treat the minister as an employee for social security tax purposes.

Now this is where understanding ministerial compensation can get kind of tricky. This is because when it comes to social security taxes, the minister is considered self-employed and is responsible to withhold and pay 100% of those taxes. 

The self-employment tax is 15.3% of the minister’s gross income.

Unlike the rest of the taxpaying population, when a minister does a tax return he/she will be responsible to pay federal income tax and self-employment taxes. Let me explain.

The Federal Insurance Contributions Act (FICA) dictates that both an employer and employee are responsible for the FICA taxes. This means that half of the 15.3% tax will be paid by the employer and the other half will be withheld from the employee’s pay. This is not the case for ministers because of their dual tax status as both an employee of the church and self-employed individual for social security tax purposes.

It is worth noting that ministers are afforded the privilege of filing for self-employment tax exemption. 

(Recommended reading: “4 Reasons Why Ministers Should Opt-Out of Social Security”)

Mistake #3: Withholding income tax without a voluntary withholding agreement.

Ministers often think that they are exempt from having to pay income taxes. However, that is simply not true. 

Rather, a minister’s wages are exempt from income tax withholding. In essence, a church should not withhold federal income tax from a minister’s pay without first signing a voluntary withholdings agreement.

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.” However, if the church and minister choose not to enter into a voluntary withholding agreement, then the minister will be responsible to use Form 1040-ES to pay income tax.

How to determine reasonable compensation for pastors

When speaking with ministers about their compensation, we are often asked, “What does the IRS consider reasonable compensation for pastors?” Unfortunately, there is not a straight answer to this question. We usually respond to this question with, “It depends.” Let me explain.

With regard to taxation, you are generally guilty until proven innocent. However, Treasury Regulation 53.4958-6 provides us with an exception to this rule, known as the presumption of reasonableness, by stating, 

“(a)In general. Payments under a compensation agreement are presumed to be reasonable. . . .” (Emphasis added.)

This is good news! However, there are some criteria that must be met by the church. In short, a pastors compensation will be considered reasonable if the church board does the following:

• Uses comparable salaries. Key factors in using comparable salaries include geographic location, church size, church income, functionally equivalent position, and the individual’s (pastor’s) qualifications;
• Documents those comparable salaries; and
• Records everything in board meeting minutes approving the salary compensation agreement and does it all before making any payments to the pastor(s).

The presumption of reasonableness is important because it relieves the church, its board, and the individual (pastor) receiving the salary from the burden of proof that the benefit was one of reasonableness.

What happened with the church in San Diego?

After spending some time looking more closely at the church’s payroll, I had a phone conversation with the pastor, church administrator, and their CPA to tell them what I discovered. It turned out that the minister had been on the church’s payroll for 2-1/2 years and the church had been withholding FICA taxes from his pay the entire time.

What was even more interesting was that the minister had filed Form 4361 and had been approved by the IRS for self-employment tax exemption. After determining that the church had incorrectly withheld FICA taxes, we were able to assist them in filing Form 941-X returns on the church’s behalf to correct the issue of the last 2-1/2 years.

The result was that the church received a refund of over $18,000.00, which by law had to be split between the church and the pastor.

Getting your compensation agreement in order

Clearly understanding ministerial compensation is of vital importance to both the minister and the church. The fact is that there are many more churches just like the one in San Diego I helped a couple of years ago. Perhaps yours is one of them.

Since understanding ministerial compensation is so vitally important, I invite you to join us at one of our Ultimate Church Structure Conferences for a day of learning and growing together. Or, if you are needing assistance in creating a ministerial compensation agreement click on the link below, or give us a call today at 877-494-4655. 

Handpicked articles for you:

• “3 Things Every Minister Should Know About Housing Allowance”
• “How to Conduct a Better Board Meeting”
• “Billy Graham Evangelistic Association Changes Its Tax Status”

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