The Pastor-Church Contract

By Richard R. Hammar, J.D., LL.M., CPA

© Copyright 1991, 1998 by Church Law & Tax Report.  All rights reserved.  This publication is designed to provide accurate and authoritative information in regard to the subject matter covered. It is provided with the understanding that the publisher is not engaged in rendering legal, accounting, or other professional service.  If legal advice or other expert assistance is required, the services of a competent professional person should be sought. Church Law & Tax Report, PO Box 1098, Matthews, NC 28106. Reference Code: m43

The relationship between a minister and his or her church is often regarded as contractual. One court has stated that “one becomes pastor of a church pursuant to a contract, made with the person or body having the authority to employ.”¹ Another court has noted that “just as a church can contract with persons outside the church membership, it can contract with its own pastor.”²

Ascertaining precisely when the contract between a minister and a church is created is important, for once a contract exists, each party possesses rights which may be protected by law. If, for example, a church agrees to employ a particular minister, but reverses its decision before the minister begins his or her duties, has a contract been created? If so, the church may be liable for breach of contract. If not, the minister is without a legal remedy. Or, is a contract created where a church offers a position to a particular minister who verbally accepts the appointment, only to repudiate it later? Again, if a contract did exist, the church may have legal recourse against the minister.

Often, a contract of employment will be implied between a church and its minister though no written agreement was signed. As one court has observed, “[t]he absence of a written contract is completely immaterial; the conduct of the parties clearly indicates an agreement to retain [the] pastor until his dismissal by the church.”³

Unfortunately, it is often difficult to ascertain whether or when a contract has been created, because a minister rarely signs a formal contract setting forth all of the terms of employment. In one case, a church entered into the following contract with a prospective minister:

Section 1. Agreement on Salary. The First Party does hereby agree to pay the Second Party One Hundred Seventy--Five ($175) Dollars per week. All church engagements are counted as part of salary. This is a starting salary. Section 2. Engagements. The Second Party cannot accept any outside engagements without first getting the approval of the First Party, even if it is a charitable affair. Section 3. Length of Contract. This contract shall be a one (1) year contract with the option to terminate, if both parties mutually agree. This contract contains the entire agreement between the parties and supersedes any and all other agreements, verbal or written, and the first party shall not be bound by any agreement or representation other than those contained herein.

The church repudiated the agreement before the minister began his duties, and the minister sued the church for breach of contract. The court concluded that “in a contract for the performance of services by one party in consideration of the payment of money by the other party, the nature and character of the services to be performed as well as the place of performance and the amount to be paid must be certain and definite. The contract here contains no description of the nature and character of the services to be performed by the minister or when or where the duties are to be performed. It is so indefinite and vague that it is unenforceable.”⁴

On the other hand, if the church's offer is in writing, and sets forth (1) the nature of the services to be performed, (2) compensation to be paid, and (3) the term of employment, an enforceable contract ordinarily will be created on the day the minister mails his or her acceptance to the church. This assumes, of course, that the church had authority to make the offer and acted in conformity with its constitution and bylaws.⁵ On that date, all of the requirements for a valid and enforceable contract exist—an offer and an acceptance, an exchange of mutually beneficial promises, and a lawful purpose.¹ Some courts have ruled that the church or prospective minister may sue to enforce such a contract if the other party defaults, even if the minister never actually began to perform services under the contract. The contract of a minister who accepts the call of a hierarchical church includes all the canons and applicable rules set forth in the organizational documents of the parent hierarchical body.²

Most courts consider an agreement to work for a certain salary per week, month, or year to be so indefinite as to be terminable at will by either party.³ A minister who agrees to work for a church for a stated annual salary is therefore not on that basis alone entitled to work for a full year. To illustrate, one church had its pastor sign a contract containing the following provision: “We promise and oblige ourselves . . . while you are dispensing spiritual blessings to us to pay you the sum of $________ in ________ payments, yearly and every year so long as you continue the minister of the church . . . . ” The minister claimed that this contract was a  “contract for life.” The court disagreed: “[A] hiring on the basis of a yearly salary, if no period of employment is otherwise stated, is terminable, without cause, at the election of either employer or employee.”⁴

As has been noted, if a valid contract exists between a church and its minister, then either party may be liable for breaching the contract, including any of the terms of employment set forth in the agreement. Employment contracts are breached most frequently by repudiation of the employment relationship prior to the expiration of the term specified in the contract. Where one party breaches the employment contract, what legal remedies are available to the innocent party? Before answering this question, it must be recognized that in recent years the civil courts have rarely allowed dismissed clergy to sue their former churches. This is because such cases typically involve matters of ecclesiastical doctrine and practice.⁵ However, it is conceivable that a minister might be terminated for reasons having nothing to do with church doctrine or practice.

Consider the following illustration. Rev. Green is hired by First Church for a three--year term, and he is terminated by the church board after only one year because the board feels that it can find someone “more effective.” The board has no complaint with Rev. Green's theology or personal conduct, and they believe that his services are adequate. The board simply feels that it can find someone “better.” Rev. Green cannot find another position for an extended period of time. He sues First Church, seeking to be paid his stated compensation for the remaining two years of the contract term. Should a civil court accept such a case? Would the case interfere with the first amendment principle of “separation of church and state”? Some courts have concluded that they do have the authority to hear these kinds of cases, since no inquiries into church doctrine or practice will be necessary. As one court has observed, the civil courts will involve themselves in a contractual dispute between a church and its pastor only if “the determination of the parties' rights can be accomplished by the application of neutral principles of law without the necessity of adjudicating matters of church doctrine or determining matters of church government in a hierarchical church.”⁶ Such courts have concluded that clergy who are dismissed prior to the expiration of a stated contract term are entitled to money damages.

Two additional factors, however, must be borne in mind. First, the suit must be filed within the time period specified in the applicable statute of limitations, which begins to run upon the expiration of the contract term.⁷ Second, the wages not paid under the terminated contract will not necessarily be the measure of damages. The minister has a legal duty to mitigate the church's damages by accepting available alternative employment of the same or similar character.⁸ If the minister diligently seeks alternative employment of the same or similar character, but none is available, he or she is entitled to sue for the full salary corresponding to the terminated portion of the employment term. If the dismissed minister does not seek other employment, then the church's liability will be reduced by the amount which the minister, with reasonable diligence, might have earned from other employment during the remaining contract term. If the minister finds work of the same or similar character during the remaining term of employment, then the church's liability will be reduced by the value of the compensation received by the minister from the new employer.

To illustrate, in one case a church discharged a minister who had served only four years of a seven--year term of employment. The discharged minister sued for breach of contract. In attempting to assess the proper monetary damages for breach of contract, the court observed:

There is evidence . . . to the effect that . . . appellant saw Mr. Bailey, the secretary of the Gulf Coast Christian churches, and applied for a regular pastorate in some church, and none was available. The evidence also shows that appellant was advised that Mr. Bailey had a number of calls for interim pastorates. The evidence is insufficient to show that appellant made any effort to obtain employment in any of such interim pastorates and it is difficult to ascertain from the record just what diligence appellant exercised to obtain employment. There is nothing in the record to the effect that appellant would not be able to obtain employment from the date the case went to trial to the time the contract would expire but for the wrongful termination thereof.⁹

Remedies other than money damages for breach of contract occasionally are recognized. One minister, who was physically ejected from his church by armed security guards hired by church trustees, was awarded injunctive relief prohibiting the trustees from interfering with his ministerial duties, and also received an award of monetary damages against the trustees and the security guards.¹⁰ However, other courts have ruled that a wrongfully discharged minister may not sue to restrain his church from “breaching and terminating the contract.” His appropriate remedy is a suit for breach of contract.¹¹

The church, as an employer, has the right to dismiss a minister before the expiration of a specified term of office under either of two theories. First, a minister can be dismissed if his or her behavior corresponds to a specific ground for dismissal expressed in his contract. A church should never discharge a minister for a contractual violation unless it has credible and convincing evidence. Churches should also avoid the use of vague terminology in reciting the grounds for termination of employment. Terms such as dishonesty, immorality, incompetence, inefficiency, and unbecoming conduct should be avoided. The grounds should be stated with sufficient clarity that neither the minister nor the church will be in doubt about their meaning. Second, a church ordinarily may dismiss a minister prior to the expiration of a specified term of employment where the minister violates an implied condition of employment. Implied conditions of employment are not stated in the contract, but are reasonable inferences of the parties' unexpressed intentions and assumptions. One court has observed:

The law implies a stipulation or undertaking by an employee in entering into a contract of employment that he is competent to perform the work undertaken and is possessed of the requisite skill and knowledge to enable him to do so, and that he will do the work of the employer in a careful manner. If he is not qualified to do the work which he undertakes, if he is incompetent, unskillful or inefficient, or if he executes his work in a negligent manner or is otherwise guilty of neglect of duty, he may be lawfully discharged before the expiration of his term of employment.¹²

The courts have also held that an incapacitating illness of long duration or an intervening mental incapacity may also be sufficient grounds for termination of an employment contract before its expiration.¹³

A minister may also breach the employment contract. Again, the most frequent example is repudiation of the employer--employee relationship without justification prior to the expiration of the employment term. In such a case the church may be allowed to sue the former minister for the cost of obtaining the services of another minister, plus any other damages resulting directly from the minister's repudiation of the contract, provided that such damages were foreseeable at the time the contract was entered into.¹⁴

Finally, an employment contract, like any contract, may be rescinded where one party fraudulently induced the innocent party to enter into the contract. In one case, a synagogue sought to rescind a contract with a rabbi on the ground that it had been defrauded by the rabbi's failure to disclose a criminal record and disbarment as an attorney. The court, in holding in favor of the synagogue, observed:

Arrangements between a pastor and his congregation are matters of contract subject to enforcement in the civil courts. Contracts in general are subject to rescission when they are obtained by fraud. . . . Legal fraud consists of a material misrepresentation of a presently existing or past fact made with knowledge of its falsity, with the intention that the other party rely thereon, and he does so rely to his damage.¹⁵

The court concluded that “a prior criminal record and disbarment from the practice of law must be disclosed by one seeking a rabbinical post involving the spiritual, religious and educational leadership of a religious congregation.”¹⁶

How does a church implement an accountable reimbursement plan? By having the church board pass an appropriate resolution containing the requirements summarized above.¹⁷ It is important to recognize that new IRS guidelines for “accountable” plans took effect July 1, 1990. The new IRS guidelines specify that an employee's “accounting” or substantiation of his or her business expenses, and the return of any excess reimbursements, must occur within a “reasonable time.” The IRS stated that the reasonable time requirement may be satisfied in two ways. First, under the “fixed date method,” business expenses will be deemed substantiated within a reasonable amount of time if done so within 60 days after the expenses are paid or incurred, and excess reimbursements will be deemed to have been returned to the employer within a reasonable amount of time if done so within 120 days after the expenses are paid or incurred. Under the alternative “periodic statement method,” an employer gives employees a periodic statement (not less often than quarterly) setting forth the amount by which the employer's reimbursements exceed the amount of business expenses substantiated by the employee, and requesting the employee to either substantiate the difference or return it to the employer within 120 days of the statement. Expenses that are substantiated, or returned, during the 120 period satisfy the reasonable time requirement. Churches that have adopted accountable reimbursement plans in the past must be familiar with these new rules, and they should modify their plans accordingly.

Churches must recognize that business expense reimbursements or allowances paid to employees on or after July 1, 1990, must be included on the employees' W--2 forms, and are subject to income tax and FICA withholding when paid—unless the reimbursements are paid under an “accountable” reimbursement plan. The withholding requirements will not apply to clergy, who are exempt from tax withholding (unless they have elected voluntary withholding). Non--minister church employees will be covered by the new rules.

Let's illustrate the significance of these rules with an example. Assume that Rev. Smith is senior minister at First Church, and that his church reimburses him for all of his business and professional expenses (by means of a credit card or cash reimbursements). However, Rev. Smith is not required to account for such expenses by providing the church treasurer with receipts documenting the amount, time and place, business purpose, and business relationship of each expense. Rev. Smith simply informs the treasurer at the end of each month of the total expenses incurred during that month. Assume further that Rev. Smith cannot itemize deductions on Schedule A (he does not have sufficient deductions), and that Rev. Smith is an employee for federal income tax reporting purposes. If Rev. Smith receives reimbursements of $4,000 from his church: (a) the church would report the entire reimbursements ($4,000) as income on Rev. Smith's W--2, and Rev. Smith would report them as income (salary) on his Form 1040; (b) Rev. Smith cannot deduct the reimbursed expenses as adjustments to gross income (on Form 1040), since they are “nonaccountable” (i.e., he did not adequately account to the church for such expenses); (c) Rev. Smith cannot deduct the reimbursed expenses as a miscellaneous itemized deduction on Schedule A since he does not have sufficient expenses to itemize. In other words, all of Rev. Smith's business expense reimbursements are includable in his income for tax purposes, but he cannot offset any of this income by deducting any portion of his business expenses. Even if Rev. Smith could itemize deductions, his nonaccountable reimbursed expenses would be treated just like unreimbursed expenses—they are deductible only as miscellaneous itemized deductions, and then only to the extent that they (along with most other miscellaneous expenses) exceed 2% of Rev. Smith's adjusted gross income. Clearly, the tax impact of the new reimbursement requirements on many clergy will be disastrous if they do not account to their employing church for their business expenses. This new rule makes it absolutely essential for churches to adopt reimbursement policies that allow reimbursements of only those business and professional expenses for which a minister (or any other church employee) provides an adequate accounting. To illustrate, if First Church adopted an accountable reimbursement plan, and Rev. Smith was reimbursed for $4,000 of substantiated expenses, then the church would not report the $4,000 of reimbursements as income on Rev. Smith's W--2, and Rev. Smith would not have to report the reimbursements or claim the expenses on his Form 1040.

There are a variety of ways for a church to “fund” an accountable reimbursement plan. First, it can agree to reimburse all substantiated business expenses without limitation. Second, it can agree to reimburse substantiated expenses up to a fixed limit (i.e., $4,000 per year). Any business expenses incurred by the minister in excess of this amount would be unreimbursed. Prior to 1991, many churches reimbursed a minister's substantiated business expenses out of his or her own compensation. For example, a church simply paid a minister's monthly business expenses out of the last weekly paycheck of the month. Whatever was left after the substantiated expenses have been reimbursed would be classified as salary and reported on the minister's W--2. Unfortunately, the IRS has disallowed this practice for 1991 and future years.¹⁸  

Churches occasionally reimburse clergy for non--business expenses. Such reimbursements, though they require an accounting, ordinarily must be included in the minister's wages for income tax reporting purposes, and they are not deductible by the minister. Such “personal, living, or family expenses” are not deductible, and the entire amount of a church's reimbursement must be included on the minister's W--2 and 1040.  

The income tax regulations permit “independent contractors” (i.e., self--employed persons) to be reimbursed for their business expenses, and such reimbursements need not be reported as income to the extent that the self--employed individual properly accounts to his or her “client or customer” for each expense that is reimbursed. Generally, the substantiation and “accounting” requirements described above for employees apply to self--employed as well. Since self--employed clergy are permitted to deduct their business expenses (whether unreimbursed or reimbursed under a nonaccountable plan) directly on Schedule C whether or not they can itemize deductions on Schedule A, there is less need for a reimbursement policy. However, an accountable reimbursement plan for self--employed persons would have the following advantages: (a) it would reduce the likelihood of additional taxes if the self--employed individual is audited by the IRS and reclassified as an employee; (b) it will reduce audit risk by permitting the individual to report to his or her church rather than to the IRS.

(4) Church--Owned Vehicles.  Churches should consider the advantages associated with acquiring an automobile for a minister's church--related travel. Here's why. If a church purchases a car, and the church board adopts a resolution restricting use of the car to church--related activities, then the church's minister reports no income or deductions, and better yet, there are no accountings, reimbursements, allowances, or recordkeeping requirements. This assumes that the car is in fact used exclusively for church--related purposes. For churches and clergy to realize these tax benefits, the following conditions must be satisfied: (a) The vehicle is owned or leased by the church and is provided to a minister (or other church employee) for use in connection with church business; (b) when the vehicle is not being used for church business, it is kept on the church's premises (unless it is temporarily located elsewhere, such as a repair shop); (c) no employee using the vehicle lives on the church's premises; (d) under a written policy statement adopted by the church board, no employee of the church can use the vehicle for personal purposes, except for de minimis (minimal) personal use (such as a stop for lunch between two business trips); (e) the church reasonably believes that, except for de minimis use, no church employee uses the vehicle for any personal purpose; and (f) the church must be able to supply sufficient evidence to prove to the IRS that the preceding five conditions have been met.¹⁹

Commuting is always considered to be personal use of a car, and accordingly the procedure discussed in the preceding paragraph would not be available if a church allowed its minister to commute to work in a church--owned vehicle. Fortunately, the regulations permit certain church employees who use a church--owned vehicle exclusively for business purposes except for commuting to receive all of the benefits associated with business use of a church--owned vehicle, if the employer values each round--trip commute at $3 and each one--way commute at $1.50 (and includes the value of all commuting on the employee's W--2), and the following conditions are satisfied: (a) The vehicle is owned or leased by the church and is provided to an employee for use in connection with church business; (b) for “noncompensatory” business reasons (i.e., security) the church requires the employee to commute to and from work in the vehicle; (c) under a written policy statement adopted by the church board, no employee of the church can use the vehicle for personal purposes, except for commuting or “de minimis” (minimal) personal use (such as a stop for lunch between two business trips); (d) the church reasonably believes that, except for commuting and de minimis use, no church employee uses the vehicle for any personal purpose; (e) the employee who is required by the church to commute to and from work in the vehicle is not a “control employee” (defined below); and (f) the church must be able to supply sufficient evidence to prove to the IRS that the preceding five conditions have been met.²⁰ The income tax regulations define a “control employee” as one who is a (a) board appointed, confirmed, or elected officer with annual compensation of $50,000 or more; (b) a director (regardless of compensation); or (c) any employee with annual compensation of $100,000 or more.²¹ Obviously, senior ministers ordinarily will not be able to take advantage of this special commuting rule, since they typically are directors of their church, and in some cases they are appointed or confirmed by the church board and receive compensation of $50,000 or more during the year. In some cases, however, ministers may be eligible for the special commuting rule. Note also that a little--noticed provision in the income tax regulations give employers the option of substituting a different definition of “control employee.”²² The substitute definition is quite complex, but it does include any employee with annual compensation of $50,000, and it does not automatically include directors. In many cases, it will be less likely that a minister will be a control employee under the substitute definition, meaning that the special commuting rule will be available to them. If a church would like to use the special rule for a minister (who is not a control employee under the substitute definition) it should specifically adopt the substitute definition by a church board resolution. The substitute test is set forth in section 1.132--8T(g) of the income tax regulations.

(5) Self--Employment Tax.  Social security benefits are financed through two tax systems.  Employers and employees each pay the “FICA” tax, which for 1991 (and all future years unless Congress specifies otherwise) amounts to 7.65 percent of an employee's taxable wages (a total tax of 15.3 percent).  Self--employed persons pay the “self--employment tax,” which for 1991 (and all future years unless Congress specifies otherwise) is 15.3 percent of net self--employment earnings. Clergy are always considered to be self--employed for social security purposes with respect to services performed in the exercise of ministry.  This means that clergy never pay FICA taxes with respect to such services.  Rather, they pay the self--employment tax (15.3 percent)—unless they have filed a timely application for exemption from social security taxes and have received written approval of their exemption from the IRS. Because clergy pay a much higher social security tax than is required of employees, many churches agree to pay a portion (i.e., one--half) of a minister's self--employment tax liability.  This is perfectly appropriate.  However, note that any portion of a minister's self--employment tax paid by a church must be reported as additional compensation on the minister's W--2 or 1099 form, and again on the minister's Form 1040.  The amount paid by the church must be reported as compensation for social security purposes as well. Note that housing allowances and the fair rental value of parsonages are includable in self--employment earnings for social security purposes.

(6) Insurance.  Churches often provide ministers with life, health, or disability insurance coverage, and pay all of the premiums for such coverage. The income tax regulations²³ specify that the gross income of an employee does not include “contributions which his employer makes to an accident or health plan for compensation (through insurance or otherwise) to the employee for personal injuries or sickness incurred by him, his spouse, or his dependents . . . .  The employer may contribute to an accident or health plan by paying the premium (or a portion of the premium) on a policy of accident or health insurance covering one or more of his employees, or by contributing to a separate trust or fund . . . .”  The IRS has ruled that amounts furnished to a conference of churches by member churches to provide hospital and medical insurance coverage for clergy employees are excludable from clergy gross income under section 106.²⁴ The exclusion of employer--paid health insurance premiums from the taxable income of employees is one of the major reasons why clergy often are better off reporting their income taxes as employees. This important benefit is not available to clergy who report their income taxes as self--employed persons.

The cost of group term life insurance bought by an employer for its employees ordinarily is not taxable to the employees so long as the amount of coverage does not exceed $50,000 per employee. Generally, life insurance can qualify as group term life insurance only if it is available to at least ten full--time employees. However, there are some exceptions to this rule.  For example, the ten full--time employee rule does not apply if (a) an employer provides the insurance to all full--time employees who provide satisfactory evidence of insurability, (b) insurance coverage is based on a uniform percentage of pay, and (c) evidence of insurability is limited to a medical questionnaire completed by the employee that does not require a physical examination.  

Other kinds of insurance premiums paid by the church on behalf of a minister ordinarily must be included in the minister's reportable compensation (Forms W--2, 1099, 1040).  For example, the cost of premiums on a whole life or universal life insurance policy paid by a church on the life of its minister (and naming the minister's spouse and children as beneficiaries) ordinarily must be reported as income to the minister.

(7) Retirement Accounts.  Most clergy participate in some form of retirement plan. Such plans often are sponsored either by the local church, or by a denomination or agency with which the minister (or his or her employing church) is affiliated.  Ministers covered by certain kinds of plans can choose to have part of their pay set aside each year (through “salary reductions”) in the retirement fund, rather than receiving it as income.  Amounts set aside by the employing church under these plans may be excludable from gross income for tax purposes. These amounts are sometimes called “elective deferrals,” because the minister chooses (elects) to set aside the money, and tax on the money is deferred until it is taken out of the account.  This option is available  to clergy who are covered by tax--sheltered annuities (“403(b) plans”), simplified employee pensions (SEPs), and certain other plans. Payments made by an employing church toward a minister's tax--sheltered annuity, SEP, and certain other plans, and funded out of church funds rather than through a reduction in a minister's compensation, may also be excluded from a minister's gross income for tax purposes under certain circumstances.  There are limits on how much of a minister's compensation he or she can elect to contribute into such plans, and on how much the employing church can contribute out of its own funds.  Of course, clergy (whether employees or self--employed for income tax purposes) can also contribute to an IRA.  Self--employed clergy may be eligible to establish a “Keogh account” (with higher annual contribution limits than IRAs).  

Retirement planning is a complex issue. The important points to bear in mind are:  (a) if a church has not established or contributed to a retirement plan for its ministers, then it should consider doing so or at least ensuring that its ministers are participating in an adequate alternative (particularly if they have exempted themselves from social security coverage), and (b) if a minister is participating in a retirement plan, the church board should determine how annual contributions to the plan will be funded (i.e., through clergy contributions, salary reductions, or church contributions), and in what amounts.

(8) Works Made for Hire.  Ministers who are authors or composers are often shocked to learn that their employing church may be the copyright owner of works that they create.  Section 201 of the Copyright Act specifies that “the employer . . . is considered the author” of a “work made for hire,” and “owns all of the rights comprised in the copyright” unless the employer and employee “have expressly agreed otherwise in a written instrument signed by them.” The Act defines a “work made for hire” as “a work prepared by an employee within the scope of his or her employment.”  To illustrate, if a minister of music composes a hymn or other musical work in his or her office in the church, during regular working hours, and using church equipment and church secretarial or clerical help, then the work almost certainly will be considered a work made for hire.  The result is that the church, and not the minister, is the copyright owner.  This means that the minister has no legal right in the work, and cannot enter into a contract with a publishing company for the publication and distribution of the work.  The same conclusion would apply to clergy who write articles or books.  

Clergy who produce articles, books, or musical works on church premises, using church equipment, and during regular office hours, should consider entering into a written agreement with their employing church regarding copyright ownership of such works. Unless the minister and church specifically agree otherwise in a signed writing, the copyright in such works probably will vest in the church.  Of course, a minister may be reluctant to mention this issue if the church is not aware that he or she is writing books or composing musical works during office hours.  But a minister who writes articles or books or composes musical works on church equipment, using church supplies, during regular office hours, and without the church's knowledge or consent, probably should not be considered the owner of the copyright in such works.  That, in any event, is the philosophy of the Copyright Act.

(9) Qualified Tuition Reductions (“QTRs”).  Many churches operate elementary or secondary schools, and charge reduced tuition to certain school employees. Such “tuition reductions” are perfectly appropriate, and section 117(d) of the Internal Revenue Code specifies that they will not result in taxable income to the school employees. In other words, a $500 annual tuition reduction awarded to a school employee whose child attends the school need not be reported as income (on the employee's W--2 or Form 1040). This obviously can be a significant benefit to school employees. However, section 117(d) also provides that “highly compensated employees” cannot exclude qualified tuition reductions from their income unless the same benefit that they receive is available on substantially similar terms to other employees.²⁵

(10) Reasonable Compensation.  In order for a church to retain its exemption from federal income taxes, it must meet several conditions, including no “inurement” (i.e., distribution) of its income to any private individual other than as reasonable compensation for services rendered.  Accordingly, a church cannot pay excessive or unreasonable compensation to its minister without jeopardizing its tax--exempt status. This important concept is defined in section C of this chapter Compensation.

(11) Loans to Clergy. Churches often make loans to clergy to enable a minister to pay for housing or some other major purchase. Typically, the church charges no interest, or a low rate far below the prevailing market rate of interest.  These loans can create problems for at a number of reasons.  Consider the following. First, many state nonprofit corporation laws prohibit loans to officers and directors.  No church should consider making any loan to a minister (even at a reasonable rate of interest) without first determining that such loans are permissible under state law. Second, no--interest or low--interest loans to clergy may be viewed as “inurement” of the church's income to a minister.  As noted in the preceding paragraph, this can potentially jeopardize the church's tax--exempt status.  Third, for loans of $10,000 or more (or for loans of lower amounts where an intent to avoid taxes exists), a church must value the benefit to a minister of receiving a no--interest or low--interest loan, and add this amount to the minister's reportable income.  This is a complex calculation that is beyond the scope of this text.  But even if loans to clergy are allowed under a state's nonprofit corporation law, the church must recognize that no--interest and low--interest loans of $10,000 or more will result in income to a minister that must be valued and reported (on the minister's W--2 or 1099--MISC, and Form 1040). Failure to do so could result in prohibited “inurement” of the church's income to a private individual, and this could be disastrous for the church.

(12) Voluntary Withholding.  Compensation paid to clergy for services performed in the exercise of their ministry is not subject to either income tax or FICA withholding—and this is so whether a minister reports his or her income as an employee or as a self--employed person.  Clergy are required to report and prepay their federal taxes by using the estimated tax procedure.  This procedure requires clergy to estimate their income tax and self--employment tax liability for each year prior to April 15th, and then to pay one--fourth of the total estimated tax liability on or by April 15, June 15, September 15, and the following January 15.  These quarterly payments are accompanied by a “payment voucher” that is contained in Form 1040--ES.  Some clergy find the estimated tax procedure inconvenient and undesirable (it is often hard to budget for the quarterly payments).  

Clergy who report their income taxes as employees can enter into a voluntary withholding arrangement with their employing church. Under such an arrangement, the employing church withholds income taxes as it would for any other employee, and also an additional amount for the minister's self--employment tax liability.  A minister need only complete and submit to his or her church an IRS Form W--4 to begin the voluntary withholding.  The arrangement can be terminated by either the minister or the church at any time. Clergy who report their income taxes as self--employed could achieve the same benefit by entering into an unofficial withholding arrangement with their church under which the church withholds amounts from each paycheck to cover the minister's quarterly estimated tax payments.  By each quarterly deadline, the church gives the minister the “withheld” compensation to assist him or her in making the quarterly payment.  No W--4 should be prepared, since this would be evidence that the minister is in fact an employee. Churches should apprise clergy that they may enter into a voluntary withholding arrangement.  For many clergy, such an arrangement will be preferable to the estimated tax procedure.

Initiating the Pastor-Church Relationship

Clergy Compensation

Termination

Nature of the Pastor-Church Relationship