Figuring Net Earnings From Self-Employment for SE Tax

There are two methods for figuring your net earnings from self-employment as a minister, member of a religious order, Christian Science practitioner, or church employee.

• Regular method, or
• Nonfarm optional method.

Regular Method

Most people use the regular method. Under this method, you figure your net earnings from self-employment by totaling your gross income for services you performed as a minister, a member of a religious order who has not taken a vow of poverty, or a Christian Science practitioner. Then, you subtract your allowable business deductions and multiply the difference by .9235 (92.35%). Use Schedule SE (Form 1040) to figure your net earnings and SE tax.

If you are an employee of a church that elected to exclude you from FICA coverage, figure net earnings by multiplying your church wages shown on Form W-2 by .9235. Do not reduce your wages by any business deductions when making this computation. Use Section B of Schedule SE (Form 1040) to figure your net earnings and SE tax.

If you have an approved exemption, or you are automatically exempt, do not include the income or deductions from qualified services in figuring your net earnings from self-employment.

For more information on net earnings from self-employment, get Publication 533.

Amounts included in gross income.   To figure your net earnings from self-employment (on Schedule SE (Form 1040)), include in gross income:

1. Salaries and fees for your qualified services (discussed earlier),
2. Offerings you receive for marriages, baptisms, funerals, masses, etc.,
3. The value of meals and lodging provided to you, your spouse, and your dependents for your employer's convenience,
4. The fair rental value of a parsonage provided to you (including the cost of utilities that are furnished) and the rental allowance (including an amount for payment of utilities) paid to you, and
5. Any amount a church pays toward your income tax or SE tax, other than withholding the amount from your salary. This amount is also subject to income tax.

For the income tax treatment of items (2) and (4), see Income Tax: Income and Expenses, later.

Example.   Pastor Roger Adams receives an annual salary of $16,500 as a full-time minister. The $16,500 includes $1,500 that is designated as a rental allowance to pay utilities. His church owns a parsonage that has a fair rental value of $5,200 per year. Pastor Adams is given the use of the parsonage. He is not exempt from SE tax. He must include $21,700 ($16,500 plus $5,200) when figuring net earnings from self-employment.

The results would be the same if, instead of the use of the parsonage and receipt of the rental allowance for utilities, Pastor Adams had received an annual salary of $21,700 of which $6,700 ($1,500 plus $5,200) per year was designated as a rental allowance.

Overseas duty.   Your net earnings from self-employment are determined without any foreign earned income exclusion or the foreign housing exclusion or deduction if you are a U.S. citizen or resident alien who is serving abroad and living in a foreign country.

For information on excluding foreign earned income or the foreign housing amount, get Publication 54.

Example.   Paul Jones was the minister of a U.S. church in Mexico. He earned $22,000 and was able to exclude it all for income tax purposes under the foreign earned income exclusion. However, Mr. Jones must include $22,000 when figuring net earnings from self-employment.

Specified U.S. possessions.   The exclusion from gross income for amounts derived in Guam, American Samoa, or the Commonwealth of the Northern Mariana Islands does not apply in computing net earnings from self-employment. Also see Residents of Puerto Rico, the Virgin Islands, Guam, the CNMI, and American Samoa, earlier, under U.S. Citizens and Resident and Nonresident Aliens.

Amounts not included in gross income.   Do not include the following amounts in gross income when figuring your net earnings from self-employment.

• Offerings that others made to the church.
• Contributions by your church to a tax-sheltered annuity plan set up for you, including any salary reduction contributions (elective deferrals), that are not included in your gross income.
• Pension payments or retirement allowances you receive for your past qualified services.
• The rental value of a parsonage or a parsonage allowance provided to you after you retire.

Allowable deductions.   When figuring your net earnings from self-employment, deduct all your nonemployee ministerial expenses. Also, deduct all your allowable unreimbursed trade or business expenses that you incur in performing ministerial services as a common-law employee of the church. Include this net amount on line 2 of Schedule SE (Form 1040).

Nonemployee ministerial expenses.   These are qualified expenses you incurred while not working as a common-law employee of the church. They include expenses incurred in performing marriages and baptisms, and in delivering speeches.

Reimbursement arrangements.   If you received an advance, allowance, or reimbursement for your expenses, how you report this amount and your expenses depends on whether the reimbursement was paid to you under an accountable plan or a nonaccountable plan. If you are not sure if you are reimbursed from an accountable plan or a nonaccountable plan, ask your employer.

Accountable plans.    To be an accountable plan, your employer's reimbursement arrangement must include all three of the following rules.

• Your expenses must have a business connection - that is, you must have paid or incurred deductible expenses while performing services as an employee of your employer.
• You must adequately account to your employer for these expenses within a reasonable period of time.
• You must return any excess reimbursement or allowance within a reasonable period of time.

Generally, if your expenses equal your reimbursement, you have no deduction and the reimbursement is not reported on your Form W-2. If your expenses are more than your reimbursement, you can deduct your excess expenses for SE tax and income tax purposes.

Nonaccountable plan.    A nonaccountable plan is a reimbursement arrangement that does not meet at least one of the three rules listed under Accountable plans. In addition, even if your employer has an accountable plan, the following payments will be treated as being paid under a nonaccountable plan.

• Excess reimbursements you fail to return to your employer.
• Reimbursement of nondeductible expenses related to your employer's business.

Your employer will combine any reimbursement paid to you under a nonaccountable plan with your wages, salary, or other compensation. Your employer will report the combined total in box 1 of your Form W-2. You can deduct your related expenses (for SE and income tax purposes) regardless of whether they are more than, less than, or equal to your reimbursement.

For more information on accountable and nonaccountable plans, get Publication 463, Travel, Entertainment, Gift, and Car Expenses.

Husband and Wife Missionary Team

If a husband and wife are both duly ordained, commissioned, or licensed ministers of a church and have an agreement that each will perform specific services for which they are paid jointly or separately, they must divide the SE income according to the agreement.

If the agreement is with one spouse only and the other spouse is not paid for any specific duties, amounts received for their services are included in only the SE income of the spouse having the agreement.

Maximum Earnings Subject to SE Tax

For 2002, the maximum net earnings from self-employment subject to social security (old age, survivors, and disability insurance) tax is $84,900 minus any wages and tips you earned that were subject to social security tax. The tax rate for the social security part is 12.4%. In addition, all of your net earnings are subject to the Medicare (hospital insurance) part of the SE tax. This tax rate is 2.9%. The combined self-employment tax rate is 15.3%.

Nonfarm Optional Method

You may be able to use the nonfarm optional method for figuring your net earnings from self-employment. In general, the nonfarm optional method is intended to permit continued coverage for social security and Medicare purposes when your income for the tax year is low.

You may use the nonfarm optional method for nonfarm SE income if you meet all of the following tests.

• Your net nonfarm profits are less than $1,733.
• Your net nonfarm profits are less than 72.189% of your gross income from nonfarm self-employment.
• You are self-employed or a partner on a regular basis. This means that your actual net earnings from self-employment are $400 or more in at least 2 of the 3 tax years before the one for which you use this method.
• You have not previously used this method more than 4 years (there is a 5-year lifetime limit). The years do not have to be consecutive.

If you meet the four tests, you may report the smaller of two thirds of the gross income from your nonfarm business, or $1,600 as your net earnings from self-employment. However, you may not report less than your actual net earnings from nonfarm self-employment.

For more information on the nonfarm optional method, get Publication 533 and Schedule SE (Form 1040).

Income Tax: Income and 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.

Designation requirement.   The church or organization that employs you must officially designate the payment as a housing allowance before the payment is made. A definite amount must be designated. The amount of the housing allowance cannot be determined at a later date.

If you are employed and paid by a local congregation, a resolution by a national church agency of your denomination does not effectively designate a housing allowance for you. The local congregation must officially designate the part of your salary that is to be a housing allowance. However, a resolution of a national church agency can designate your housing allowance if you are directly employed by the agency. If no part has been officially designated, you must include your total salary in your income.

Rental allowances.    If you receive in your pay an amount officially designated as a rental allowance (including an amount to pay utility costs), 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 amount you exclude cannot be more than the fair rental value of the home, including furnishings, plus the cost of utilities.

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.

Excess rental allowance.   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.

Include the excess rental allowance on line 7 of Form 1040.

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.

Teachers or administrators.   If you are a minister employed as a teacher or administrator by a church school, college, or university, you are performing ministerial services for purposes of the housing exclusion. However, if you perform services as a teacher or administrator on the faculty of a nonchurch college, you cannot exclude from your income a housing allowance or the value of a home that is provided to you.

If you live in faculty lodging as an employee of an educational institution or academic health center, all or part of the value of that lodging may be nontaxable under a different rule. See Faculty lodging in the discussion on meals and lodging under Fringe Benefits, in Publication 525.

If you serve as a minister of music or minister of education, or serve in an administrative or other function of your religious organization, but are not authorized to perform substantially all of the religious duties of an ordained minister in your church (even if you are commissioned as a minister of the gospel), the housing exclusion does not apply to you.

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 also may 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:

Tax free rental or parsonage allowance

All income (taxable and tax-free) earned from your ministry

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:

($10,000 ÷ $40,000) x $3,500 = $875

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

($10,000 ÷ $40,000) x $500 = $125

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 2002, the percentage is 70%.

If you qualify, you can take this deduction as an adjustment to income on line 30, 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 29 of Form 1040.

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

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