Income Tax: Income & Expenses

Some income and expense items are treated the same for income tax and SE tax purposes and some are treated differently.

Income Items

The tax treatment of offerings and fees, outside earnings, rental allowances, rental value of parsonage, pay of members of religious orders, and foreign earned income is discussed here.

Offerings and Fees

If you are a member of the clergy, you must include in your income offerings and fees you receive for marriages, baptisms, funerals, masses, etc., in addition to your salary. If the offering is made to the religious institution, it is not taxable to you.

Outside Earnings

If you are a member of a religious organization and you give your outside earnings to the organization, you still must include the earnings in your income. However, you may be entitled to a charitable contribution deduction for the amount paid to the organization. Get Publication 526.

Exclusion of Rental Allowance and Fair Rental Value of a Parsonage

Ordained, commissioned, or licensed ministers of the gospel may be able to exclude the rental allowance or fair rental value of a parsonage that is provided to them as pay for their services. Services include:

• Qualified services, discussed earlier,
• Administrative duties and teaching at theological seminaries, and
• The ordinary duties of a minister performed as an employee of the United States (other than as a chaplain in the Armed Forces), a state, possession, political subdivision, or the District of Columbia.

This exclusion applies only for income tax purposes. It does not apply for SE tax purposes, as discussed earlier under Figuring Net Earnings From Self-Employment for SE Tax.

Rental allowances. If you receive in your pay an amount officially designated as a rental allowance, you can exclude the allowance from your gross income if:

• The amount is used to provide or rent a home, and
• The amount is not more than reasonable pay for your services.

The term rental allowance includes an amount to pay utility costs.

Fair rental value of parsonage. You can exclude from gross income the fair rental value of a house or parsonage, including utilities, furnished to you as part of your pay. However, the exclusion cannot be more than the reasonable pay for your services. If you pay for the utilities, you can exclude any allowance designated for utility costs, up to your actual cost.

Example. Rev. Joanna Baker is a full-time minister at the Central Mission Church. The church allows her to use the parsonage that has an annual fair rental value of $4,800. The church pays her an annual salary of $13,200, of which $1,200 is designated for utility costs. Her utility costs during the year were $1,000.

For income tax purposes, Rev. Baker excludes $5,800 from gross income (the fair rental value of the parsonage plus $1,000 from the allowance for utility costs). She will report $12,200 ($12,000 salary and $200 of unused utility allowance). Her income for SE tax purposes, however, is $18,000 ($13,200 salary + $4,800 fair rental value of the parsonage).

Home ownership. If you own your home and you receive as part of your pay a housing or rental allowance, you may exclude from gross income the smallest of the following:

• The amount actually used to provide a home,
• The amount officially designated as a rental allowance, or
• The fair rental value of the home, including furnishings, utilities, garage, etc.

You must include in gross income the amount of any rental allowance that is more than the smallest of your reasonable pay, the fair rental value of the home plus utilities, or the amount actually used to provide a home.

You may deduct the home mortgage interest and real estate taxes you pay on your home even though all or part of the mortgage is paid with funds you get through a tax-free rental or parsonage allowance.

Retired ministers. If you are a retired minister, you exclude from your gross income the rental value of a home (plus utilities) furnished to you by your church as a part of your pay for past services, or the part of your pension that was designated as a rental allowance. However, a minister's surviving spouse cannot exclude the rental value unless the rental value is for ministerial services he or she performs or performed.

Theological students. If you are a theological student serving a required internship as a part-time or assistant pastor, you cannot exclude a parsonage or rental allowance from your income unless you are ordained, commissioned, or licensed as a minister.

Traveling evangelists. You can exclude a designated rental allowance from out-of-town churches if you meet all of the following requirements.

• You are an ordained minister.
• You perform qualified services at churches located away from your community.
• You actually use the rental allowance to maintain your permanent home.

Cantors. If you have a bona fide commission and your congregation employs you on a full-time basis to perform substantially all the religious functions of the Jewish faith, you can exclude a rental allowance from your gross income.

Pay--Members of Religious Orders

Your pay may be exempt from both income tax and SE tax if you are a member of a religious order who:

• Has taken a vow of poverty,
• Receives pay for services performed as an agent of the order and in the exercise of duties required by the order, and
• Renounces the pay and gives it to the order.

See Members of Religious Orders, earlier, under Social Security Coverage.

Foreign Earned Income

Certain income may be exempt from income tax if you work in a foreign country or in a specified U.S. possession. Publication 54 discusses the foreign earned income exclusion. Publication 570, Tax Guide for Individuals With Income From U.S. Possessions, covers the rules for taxpayers with income from U.S. possessions. You can get these free publications from the Internal Revenue Service or from most U.S. Embassies or consulates.

Expense Items

The tax treatment of ministerial trade or business expenses, expenses allocable to tax-free income, and health insurance costs is discussed here.

Ministerial Trade or Business Expenses as an Employee

When you figure your income tax, you must itemize your deductions on Schedule A (Form 1040) to claim allowable deductions for ministerial trade or business expenses incurred while working as an employee. You may also have to file Form 2106, Employee Business Expenses (or Form 2106-EZ).

These expenses are claimed as miscellaneous itemized deductions and are subject to the 2%-of-adjusted-gross-income (AGI) limit. See Publication 529 for more information on this limit.

Additionally, these expenses may have to be reduced by the amount that is allocable to tax-free income (discussed next) before being limited by the 2% AGI limit.

Expenses Allocable to Tax-Free Income

If you receive a rental or parsonage allowance that is exempt from income tax (tax free), you must allocate a portion of the expenses of operating your ministry to that tax-free income. You cannot deduct the portion of your expenses that is allocated to your tax-free rental or parsonage allowance.

Exception. This rule does not apply to your deductions for home mortgage interest or real estate taxes on your home.

Figuring the allocation. Figure the portion of your otherwise deductible expenses that you cannot deduct (because that portion must be allocated to tax-free income) by multiplying the expenses by the following fraction:

When figuring the allocation, include the income and expenses related to the ministerial duties you perform both as an employee and as a self-employed person.

Reduce your otherwise deductible expenses only in figuring your income tax, not your SE tax.

Example. Rev. Charles Ashford received $40,000 in ministerial earnings consisting of a $28,000 salary for ministerial services, $2,000 for weddings and baptisms, and a $10,000 tax-free parsonage allowance. He incurred $4,000 of unreimbursed expenses connected with his ministerial earnings. $3,500 of the $4,000 is related to his ministerial salary, and $500 is related to the weddings and baptisms he performed as a self-employed person.

The nondeductible portion of expenses related to Rev. Ashford's ministerial salary is figured as follows:

The nondeductible portion of expenses related to Rev. Ashford's wedding and baptism income is figured as follows:

Required statement. If you receive a tax-free rental or parsonage allowance and have ministerial expenses, attach a statement to your tax return. The statement must contain all of the following information.

• A list of each item of taxable ministerial income by source (such as wages, salary, weddings, baptisms, etc.) plus the amount.
• A list of each item of tax-free ministerial income by source (parsonage allowance) plus the amount.
• A list of each item of otherwise deductible ministerial expenses plus the amount.
• How you figured the nondeductible part of your otherwise deductible expenses.
• A statement that the other deductions claimed on your tax return are not allocable to your tax-free income.

See the statement prepared for the Comprehensive Example, later.

Health Insurance Costs of Self-Employed Ministers

If you are self-employed, you may be able to deduct a percentage of the amount you pay for health insurance premiums and qualified long-term care insurance for yourself and your family. For 2001, the percentage is 60%.

If you qualify, you can take this deduction as an adjustment to income on line 28, Form 1040. There is a worksheet in the instructions for Form 1040 that you can use to figure this deduction.

The following special rules apply to the self-employed health insurance deduction.

• The expenses taken into account for purposes of this deduction are not allowed as a medical expense deduction on Schedule A.
• The deduction is not allowed for any month you are eligible to participate in a subsidized plan of your (or your spouse's) employer.
• The deduction is not used to reduce your net earnings for your SE tax.
• The deduction cannot exceed your net earnings from the business under which the insurance plan is established. Your net earnings under this rule do not include the income you earned as a common-law employee (discussed earlier) of a church.

More information. For more information about the self-employed health insurance deduction, see chapter 7 in Publication 535.

Deduction for SE Tax

You can deduct one-half of your SE tax in figuring adjusted gross income. This is an income tax deduction only, and you deduct it on line 27 of Form 1040.

This is not a deduction in figuring net earnings from self-employment subject to SE tax.

Income Tax Withholding and Estimated Tax

The federal income tax is a pay-as-you-go tax. You must pay the tax as you earn or receive income during the year. An employee usually has income tax withheld from his or her pay. However, your pay is generally not subject to federal income tax withholding if both the following conditions apply.

• You are a duly ordained, commissioned, or licensed minister, a member of a religious order (who has not taken a vow of poverty), or a Christian Science practitioner.
• Your pay is for qualified services (see Qualified Services, earlier).

If your salary is not subject to withholding, or if you do not pay enough tax through withholding, you might have to pay estimated tax to avoid penalties for not paying enough tax as you earn your income.

You generally must make estimated tax payments if you expect to owe taxes, including self-employment tax, of $1,000 or more when you file your return.

Determine your estimated tax by using the worksheet in Form 1040-ES. Then, using the Form 1040-ES payment voucher, pay the entire estimated tax or the first installment by April 15, 2002. The April 15 date applies whether or not your tax home and your abode are outside the United States and Puerto Rico. For more information get Publication 505, Tax Withholding and Estimated Tax.

If you perform your services as a common-law employee of the church and your pay is not subject to income tax withholding, you can enter into a voluntary withholding agreement with the church to cover any income and SE tax that may be due.

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