Ministers get a W-2, so why do they owe self-employment tax?

A minister's tax return doesn't work like anyone else's. The same paycheck is treated one way for income tax and another way for Social Security and Medicare, and part of it may not be taxed as income at all.

If you prepare returns for pastors or other members of the clergy, or expect to, the same handful of rules comes up every time. Knowing them before your client sits down saves you from amended returns and uncomfortable phone calls later.

First question: Is your client a minister for tax purposes?

Everything else depends on this answer, and the job title alone doesn't settle it. For federal tax purposes, ministers generally are individuals who are duly ordained, commissioned or licensed by a religious body constituting a church or church denomination and are authorized to perform ministerial functions. Publication 517, Social Security and Other Information for Members of the Clergy and Religious Workers, explains the applicable rules.

The work matters, too. Reg. §1.1402(c)-5 identifies three kinds of services performed in the exercise of ministry:

1. Performing sacerdotal functions
2. Conducting religious worship
3. Controlling, conducting and maintaining religious organizations under the authority of a church

A client who qualifies as a minister and performs services in the exercise of ministry gets the special tax treatment below. A church employee who isn't ordained, commissioned or licensed, such as an office manager, generally doesn't receive this treatment.

How the pay gets reported, and why two taxes treat it differently

A minister who earns a salary from a church is usually a common-law employee for income tax. The church reports the salary in Box 1 of Form W-2, Wage and Tax Statement, and leaves Boxes 3 through 6 blank for ministerial earnings. A minister's earnings aren't subject to mandatory federal income tax withholding, so your client either agrees to voluntary withholding or pays with Form 1040-ES, Estimated Tax for Individuals. Fees paid directly to the minister for weddings, baptisms and funerals typically go on Schedule C (Form 1040), Profit or Loss From Business (Sole Proprietorship).

For Social Security and Medicare, the same minister is self-employed with respect to ministerial services. Those blank boxes don't mean the tax goes away. Your client generally pays self-employment tax on Schedule SE (Form 1040), Self-Employment Tax, based on ministerial W-2 earnings, net earnings from ministerial Schedule C activities and the housing allowance included under §1402(a)(8). One common exception is an approved Form 4361, Application for Exemption From Self-Employment Tax for Use by Ministers, Members of Religious Orders and Christian Science Practitioners. The application generally must be filed by the due date, including extensions, of the return for the second tax year in which your client has at least $400 in net earnings from self-employment, with any portion attributable to ministerial services. The objection must be religious or conscientious, not financial.

The housing allowance and the deductions it reduces

Section 107 lets a minister exclude a housing allowance from gross income, within limits. The church has to designate the amount before paying it. For a minister who owns a home, the exclusion is the smallest of the amount actually used to provide the home, the amount designated, and the home's fair rental value, including furnishings, utilities and a garage. It also can't exceed reasonable pay for the minister's services. The taxable excess goes on Form 1040, U.S. Individual Income Tax Return, Line 1h.

That exclusion has a cost that clients often miss. Under §265(a)(1), expenses allocable to tax-exempt income generally aren't deductible, so your client loses part of the deduction for otherwise deductible ministry business expenses. Publication 517 gives the fraction: the tax-free allowance divided by all ministry income, taxable and tax-free. If $20,000 of $80,000 in ministry income is excluded, 25% of otherwise deductible ministry business expenses isn't deductible for income tax purposes. Qualified home mortgage interest and real estate taxes aren't disallowed merely because they were paid with the housing allowance. The allocation reduction applies to income tax deductions, not the calculation of net earnings from self-employment, and the IRS instructs ministers to attach a statement showing the allocation.

Worth a closer look

Ministers often can't get clear answers from a church treasurer or tax software, so they rely on you. Get these rules right and word travels quickly through a congregation.

If you'd like to work through these rules with examples, join NATP's Nov. 5 Assisting Ministers with Tax Issues webinar, taught by Jeffry Alvey, EA. The webinar is also available on demand after the live event. You'll learn to identify who meets the definition of a minister, report ministerial compensation, calculate the §107 exclusion, figure self-employment tax and allocate expenses between taxable income and the tax-free allowance.