TAXES [Employee or Self Employed ?]


INTRODUCTION

Most new ministers should report their federal income taxes as employees,
  • because they will be considered employees under the tests currently used by the IRS and the courts.
    Most clergy will be “better off” reporting as employees, since:
  • (1) the value of various fringe benefits will be excludable, including the cost of employer-paid health insurance premiums on the life of the minister,
  • (2) the risk of an IRS audit is substantially lower, and
  • (3) reporting as an employee avoids the additional taxes and penalties that often apply to self-employed clergy who are audited by the IRS and reclassified as employees.
    There are two ways for a minister to report federal income taxes
  • —as an employee or
  • —as a self-employed person.
    What difference does it make, and which way should a minister report?
    These are the issues addressed in this lesson for new ministers.

    What difference does it make?

    The question of whether ministers should report their federal income taxes as an employee or as a self-employed is a significant question for many reasons,
    including the following:
    (1) Reporting compensation.
    Employees report their compensation directly on Form 1040 (line 7—wages).
    Self-employed persons report compensation and business expenses on Schedule C.
    (2) Adjusted gross income.
    Adjusted gross income is higher for ministers who report their income taxes as employees if they have unreimbursed or “nonaccountable” reimbursed business expenses since these expenses are "page two" or "below the line" deductions that are claimed after adjusted gross income is computed.
    Self-employed persons deduct business expenses in computing adjusted gross income.
    Adjusted gross income is a figure that is important for many reasons.
    For example, the percentage limitations applicable to charitable contributions and medical expense deductions are tied to adjusted gross income.
    (3) W-2 or 1099?
    Ministers working for a church or church agency should receive a Form W-2 each year if they are employees, and a Form 1099-MISC if they are self-employed (and receive at least $600 in compensation).
    (4) Tax treatment of various fringe benefits.
    Certain fringe benefits provided by a church on behalf of a minister are excludable from the minister’s income only if he or she is an employee.
    Examples include medical insurance premiums paid by a church on behalf of its minister; group term life insurance (up to $50,000) provided by a church on behalf of a minister; amounts payable to employees on account of sickness, accident, or disability pursuant to an employer-financed plan; employer-sponsored “cafeteria plans” which permit employees to choose between receiving cash payments or a variety of fringe benefits.
    (5) Audit risk.
    Self-employed persons face a much higher risk of having their tax returns audited. Why?
    IRS data reveals that the “voluntary reporting percentage” (i.e., persons who voluntarily report the correct amount of income) is much higher for employees.
    (6) Consequences of being reclassified as an employee.
    Ministers who report their federal income taxes as self-employed face a significant risk of additional taxes and penalties if they are audited by the IRS and reclassified as employees.
    This is because many ministers who report as self-employed deduct their unreimbursed (and “nonaccountable” reimbursed) business expenses as a deduction on Schedule C.
    If they are reclassified by the IRS as employees, their business expense deduction will be allowable only as an itemized deduction on Schedule A,
    and then only to the extent that the expenses exceed 2% of adjusted gross income.
    Ministers who are not able to itemize end up with no deduction for their business expenses.
    This can result in a substantial increase in taxable income.
    The primary disadvantage of employee status is that most business expenses are deductible only as itemized deductions on Schedule A (i.e., the minister must be able to itemize deductions in order to deduct them),
    and they are deductible only to the extent that they exceed 2% of adjusted gross income.
    But, this “disadvantage” can be overcome simply by having your employing church adopt an accountable reimbursement policy under which the church reimburses you for those business expenses that you periodically substantiate.

    Employee or Self-Employed—What Difference Does it Make?

    Issue If an employee If self-employed How to decide if a worker is
    an employee or self-employed
    social security • employer and employee each pay FICA tax of 7.65% of employee wages (total tax of 15.3%)
    • ministers are never employees with regard to their ministerial duties (they do not pay FICA taxes)
    • nonminister church workers who are employees for income taxes are employees for social security (unless church filed a timely waiver from FICA taxes--in which case they are treated as self-employed for social security)    		 • pay 15.3% self-employment tax
    • use Schedule SE (Form 1040)
    • ministers always are self-employed with regard to their ministerial duties
    • nonminister church workers who are self-employed for income taxes are self-employed for social security    		 use income tax tests
    income taxes • wages reported by employer on W-2
    • wages reported by worker on line 7 (Form 1040)
    • unreimbursed and nonaccountable reimbursed expenses are deducted on Schedule A (subject to 2% floor)
    • low audit risk
    • some fringe benefits (such as employer paid medical insurance premiums and cafeteria plans) tax-free     		• income reported by employer on 1099
    • wages reported by worker on Schedule C and line 12 (Form 1040)
    • unreimbursed and nonaccountable reimbursed expenses are deducted on Schedule C
    • higher audit risk
    • some fringe benefits (such as employer paid medical insurance premiums and cafeteria plans) are taxable
    • church issues 1099 (if annual compensation is $600 or more)     		IRS applies a 20 factor test,
    the Tax Court has adopted various tests?
    all focus on the degree of "control" exercised by the employer over the details of how the worker performs his or her job

    Employee or self-employed?

    The IRS and the courts have applied a bewildering number of tests to determine whether a minister is an employee or self-employed for federal income tax reporting purposes.
    However, there are three simple rules that will resolve most cases.
  • • Senior ministers employed by a multi-staff church will almost always be treated as employees by the IRS for federal income tax reporting purposes.
  • • Associate ministers (e.g., youth, music) will almost always be treated as employees by the IRS for federal income tax reporting purposes.
  • • Senior ministers who are the only paid worker at smaller churches may be self-employed for federal income tax reporting purposes depending on the level of control exercised by the church board or congregation over how they perform their duties.
    • For those of you wanting a more detailed explanation, a table summarizes every IRS and court ruling addressing this issue.
    Are Ministers Employees or Self-Employed for Federal Income Tax Reporting Purposes?
    A Summary of All Cases and Rulings
    Case Test Conclusion
    IRS Letter Ruling 9825002 (1998) applied 7 factor test adopted in the Weber case (see below) denominational official was an employee
    Alford v. United States, 116 F.3d 334 (8th Cir. 1997) (1) the hiring party's right to control the manner and means by which the product is accomplished;
    (2) the skill required;
    (3) the source of the instrumentalities and tools;
    (4) the location of the work;
    (5) the duration of the relationship between the parties;
    (6) whether the hiring party has the right to assign additional projects to the hired party;
    (7) the extent of the hired party's discretion over when and how long to work;
    (8) the method of payment;
    (9) the hired party's role in hiring and paying assistants;
    (10) whether the work is part of the regular business of the hiring party;
    (11) whether the hiring party is in business;
    (12) the provision of employee benefits     		Assemblies of God pastor who served as sole employee of a small church was self-employed
    Radde v. Commissioner, T.C. Memo. 1997?490 (1997) applied 7 factor test adopted in the Weber case (see below) Methodist minister was an employee
    Greene v. Commissioner, T.C. Memo. 1996?531 (1996) applied an 8 factor test, which included all 7 factors in the Weber case (see below), plus an inquiry into whether fringe benefits provided by the employer are "typical" of those provided to employees Assemblies of God foreign missionary was self-employed
    Weber v. Commissioner, 103 T.C. 378 (1994), aff'd 60 F.3d 1104 (4th Cir. 1995) (1) the degree of control exercised by the employer over the details of the work;
    (2) which party invests in the facilities used in the work;
    (3) the opportunity of the individual for profit or loss;
    (4) whether or not the employer has the right to discharge the individual;
    (5) whether the work is part of the employer's regular business;
    (6) the permanency of the relationship;
    (7) the relationship the parties believe they are creating    		 Methodist minister was an employee
    Shelley v. Commissioner, T.C. Memo. 1994?432 (1994) applied 7 factor test adopted in the Weber case (see above) Pentecostal Holiness minister was self-employed
    IRS Letter Ruling 9825002 (1998) applied 7 factor test adopted in the Weber case (see above) denominational official was an employee
    IRS Letter Ruling 9414022 (1994) applied the 20 factor test of Revenue Ruling 87-41:
    (1) employees must comply with employer instructions;
    (2) employees more likely to be trained;
    (3) employees' work is integral part of employer's business;
    (4) self-employed workers hire and pay substitutes;
    (5) self-employed workers hire and pay assistants;
    (6) employees have continuing relationship with employer;
    (7) employees work set hours;
    (8) employees more likely to work full time;
    (9) employees do work on employer's premises;
    (10) employees do work in sequence set by employer;
    (11) employees submit oral or written reports;
    (12) employees paid by hour or week, self-employed by the job;
    (13) employees more likely to have business expenses reimbursed by employer;
    (14) self-employed provide their own tools and materials;
    (15) employees use equipment and facilities provided by employer;
    (16) self-employed may realize profit or loss;
    (17) self-employed work for more than one employer at same time;
    (18) self-employed advertise their services to the public;
    (19) employees can be dismissed;
    (20) employees can quit at any time    		 youth pastor was an employee
    IRS Letter Ruling 8333107 (1983) applied the "common law" employee test in the income tax regulations,
    which states that "generally the relationship of employer and employee exists when the person for whom services are performed has the right to control and direct the individual who performs the services,
    not only as to the result to be accomplished by the work but also as to the details and means by which that result is accomplished"    		 associate pastor was an employee
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