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WEB-EXCLUSIVE: Church payroll and tax laws

What you need to know now

Sabra_RowleyQ & A with Sabra Rowley, CPA, Assistant Vice President, Affiliate Operations at Brotherhood Mutual Insurance Company in Fort Wayne, IN

  • It has been suggested that churches need to “beef up” their Human Resources Information Solutions (HRIS) and payroll systems to provide the Federal Government with data on all employees. Is this an accurate statement?
  •  What additional / more in-depth data is the IRS looking for? (Examples: Hours worked? Salary benefits offered? Rates for the benefits offered — including employer and employee contribution levels?)
  •  What kinds of ramping-up activities should churches be investigating / starting now to avoid it being a “fire drill” when tax time comes around? (And, who needs to be enlisted to make that happen?)

ROWLEY: Generally, the more employees a church has, the more likely it will need to comply with federal regulations, and the greater the benefit of an HRIS system. Smaller churches also can benefit from payroll systems if they help employees navigate the unique clergy tax laws that apply to ministers.


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Too often, churches wrongly assume they’re exempt from the Fair Labor Standards Act (FLSA), which governs employer pay practices and the Department of Labor (DOL) enforces. In fact, the FLSA covers nearly all ministries.

The DOL most frequently wants to know if employers pay the federal minimum wage, overtime after someone works 40 hours in a week, and overtime worth at least 1.5 times a worker’s regular hourly wage. It also gives special attention to employee classifications: exempt or non-exempt; determined by specific criteria based on how the employee is paid, how much the employee is paid, and the employee’s job duties. Churches face unique challenges when hourly (non-exempt) employees want to volunteer their time at church. Hourly employees cannot volunteer for work they are being paid to do.

For organizations with 50 or more employees, the Internal Revenue Service (IRS), which enforces the federal tax code, might begin looking at costs related to health insurance. Consequently, churches might need to track how they pay medical insurance, medical reimbursement, or health savings account benefits to employees. Churches that have an HRIS system can significantly reduce the manual process to provide this information.

To stay ahead of a DOL or IRS inquiry, those responsible for church business affairs should:

  • Learn about federal wage and hour rules.
  • Monitor the hours that church employees work and where they volunteer within the church.
  • Maintain detailed pay records and ensure that their systems provide easy access to reportable information.

You’ve said that church payroll and tax laws are garnering increased scrutiny from the IRS these days. When did that start, and what were the catalysts for the increased scrutiny?

ROWLEY: The IRS has always performed payroll tax audits for all employers, making it difficult to pinpoint a starting date for increased scrutiny. Most feedback is anecdotal, received from customers and industry leaders. Two trade publications recently featured articles about payroll tax compliance issues. Some professionals believe that payroll audits are a way for the IRS to examine churches without having to comply with the Church Audit Procedures Act (IRC §7611) because payroll tax audits are not subject to its requirements.


A common mistake churches make is paying Medicare/FICA contributions on behalf of their ministers. As a result, the IRS can impose fines for incorrectly preparing W-2s and other payroll forms.


You’ve also said that, in many cases, churches are found non-compliant during an audit. Please walk us through some of the common factors behind this non-compliance.

ROWLEY: MinistryWorks is a payroll service bureau, so we don’t typically represent customers in audits. However, there are several general issues that can present compliance problems for churches.

Dual tax status

Most ministers have “dual tax status,” meaning a minister is an employee of the church for federal income tax purposes and self-employed for Social Security and Medicare (FICA) purposes.

Most clergy members meet the IRS definition of a minister and therefore are not required to withhold federal income taxes from their paycheck. This rule is unique to clergy, but ministers are still required to pay taxes. To cover a minister’s tax liability, the church can withhold income taxes at the minister’s request and report the withholding on the minister’s W-2.

Ministers, not churches, are responsible for paying into the Social Security/Medicare system through a self-employment tax, reported on the minister’s Form 1040. Ministers can either remit payments with a Form 1040-ES or elect to withhold sufficient federal income taxes to cover their self-employment tax liability.

A common mistake churches make is paying Medicare/FICA contributions on behalf of their ministers. As a result, the IRS can impose fines for incorrectly preparing W-2s and other payroll forms.

Housing allowances

Housing allowances are exempt from federal income taxes as long as the church officially designates them as such. Church leaders must enter the amount of the housing allowance into the minister’s employment contract or the church board’s meeting minutes. This designation must occur at the start of each year; it cannot be done retroactively.

Housing allowances are not exempt from Social Security taxes. Ministers need to enter their total income from ministerial services on their self-employment tax form (Form 1040, Schedule SE), including the sum of their salary and housing allowance.

Monetary gifts to pastors and other employees

Depending on the process used to collect and distribute monetary gifts to ministers and other church employees, these gifts may need to be reported to the IRS as part of the recipient’s taxable income.

Generally, monetary gifts given directly to ministers or church employees by a church member are considered non-taxable to the recipient. However, the intent of the giver and the amount of the gift might make it taxable. Regardless, the giver cannot report the gift as a tax deduction.

Any monetary gift that the church gives to its ministers or employees on behalf of the congregation is considered taxable income to the recipient because the church gave it directly to them. The amount of the gift must be included on the recipient’s W-2 and reported on his/her Form 1040. Both the church and the employee could be held liable in an audit for incorrect reporting of taxable income.

Other issues

When the IRS conducts an audit, the auditor wants to see evidence that the church is properly classifying its employees and identifying who is a minister and who is not. To be classified as clergy, the individual must be ordained, licensed, or commissioned, plus meet three of these factors:

  • Administer ordinances
  • Conduct religious worship
  • Have management responsibilities in the church
  • Be considered a religious leader in the church.

Church administrators should maintain records that demonstrate how their ministers meet these requirements.

What are the potential ramifications of non-compliance as a result of an audit?

ROWLEY: The IRS can assess fines and penalties on the church and an employee for under-reporting or improperly reporting taxable income. A more serious issue is the willful failure of the responsible person to remit payroll withholding taxes to the IRS. The fines for failing to pay these taxes can equal 100 percent of the tax due and, in some cases, result in imprisonment if the courts believe that the responsible party’s actions were intentional.

Rowley attends Pathway Community Church in Fort Wayne, IN, where she’s been involved in various ministries since the church’s inception. She spent five years as the financial officer and currently serves on the financial oversight committee.

 

 

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