June 21, 2012
Compensation Planning for Churches, Part 6
Determining the taxability of benefits and other compensation
Editor’s Note: Today is part six of a multiple-part series reviewing church compensation planning that complies with IRS guidelines. Last week we looked at how to properly classify employees who are ministers.
Determining the parts of compensation that are taxable is the most crucial step of the compensation planning process and is also a step often missed in properly reporting compensation. There is a tendency to ignore all the benefits and cash that do not flow through the payroll system. The result is a tendency to underreport income. When a church fails in its duty to properly report taxable income, it places its employees in serious jeopardy of potential penalties, additional taxes, and even jail time.
Each element of the compensation package has to be evaluated to see if it is taxable. Remember, everything is taxable until a provision in the Internal Revenue Code says that it is not. Therefore, it should be presumed that something is taxable until it can be proven that it is not taxable.
Remember, when determining taxability, it must be determined for purposes of federal income tax, Social Security tax (FICA), and Medicare tax, if the compensation is for a nonminister employee. If it’s for a minister, then the employer is only concerned about the taxability for purposes of federal income tax.
Making Determinations by Comparison
One of the biggest dangers is to make the determination based on what someone else is doing. You know how the story goes: Minister Joe goes to breakfast with all the other area ministers. He returns after one particular breakfast and says Minister Steve at First Church has full childcare at the church’s facilities and doesn't pay any tax on that benefit. Based on this information, Minister Joe now requests that he be able to place his children in the church daycare center free of charge and the value of the benefit should not be taxable to him.
Here are three ways to respond to any comparisons like this:
- First, fact check: Does Minister Steve really know what is taxable to him?
- second, don't assume that First Church is doing things correctly. It is possible for large and well-established churches or organizations to not do things correctly; and
- third, find out how First Church could be providing such a benefit tax free and then pursue that avenue.
Know the Hoops to Jump Through
Many areas of the tax law provide for tax-free treatment of various fringe benefits. However, almost all of them require certain actions taken by the employer to achieve this preferential status. In the example above, First Church may have instituted a qualified dependent care plan. Such a plan, when it meets a series of qualifications, provides for tax free dependent care. Without meeting all the requirements, the benefit would be taxable to the employee.
Common benefits that are virtually always taxable include:
- Cash: In any form, cash is virtually always taxable. This includes anniversary and birthday gifts, love offerings, flat allowances, and gift cards.
- Autos: Outside of a documented reimbursement at the standard mileage rate, any other benefit connected to an auto has a taxable component. If the organization is actually providing the auto, there is always a taxable component. These rules have been around since 1984.
- Housing: Housing provided to employees who are not ministers is most likely taxable. There are some exclusions, and they should be carefully considered. If the employee is a minister, it is taxable unless it is specifically designated in writing and in advance of payment that it is provided under IRC Section 107 as a housing allowance or a parsonage.
Common benefits that normally require written plans and nondiscrimination requirements include:
- Life insurance;
- Dependent care;
- Tuition assistance;
- Tuition reduction;
- Payment of out-of-pocket medical costs; and
- Retirement plan contributions (there are some exceptions for churches).
Next in the series: Payroll reporting
For more information on how to determine the taxability of church employee benefits and other compensation, see the 2012 Church & Clergy Tax Guide by Richard Hammar.