Do Churches Pay Employment Taxes?
Payroll taxes are complicated enough, but church payroll taxes present unique nuances. How does the IRS define a church? How are clergy members different than church employees? Do churches pay payroll taxes? Which workers qualify as employees and which are considered independent contractors?
This article provides an overview of what payroll taxes churches pay and how compliance is different for religious institutions. We’ll also discuss how the right payroll and tax compliance partner can streamline this process.
An Overview of Churches and Taxes
The topic of taxes for churches is complicated and easily misunderstood. Payroll taxes for churches is a division all unto itself, with set regulations from the IRS but little in resources because this area of tax compliance is niche.
Here are a few things to be aware of when it comes to the Internal Revenue Service (IRS) and church taxes:
- The IRS does generally consider churches to include all places of worship, including synagogues and mosques.
- There are 14 criteria the IRS uses to determine whether or not an organization qualifies as a church. The IRS does not specify how many of the requirements an organization has to meet. However, an organization does not have to meet all 14 criteria to be considered a church.
- If a church meets the five criteria in Publication 1828, Section 501(c)(3) of the IRS code, it is considered tax-exempt, though unrelated business income is still subject to income tax.
Thanks to the First Amendment of the Constitution of the United States, churches do not have to file any paperwork with the IRS to receive their tax exemption — the exemptions for churches are automatic. And unlike other tax-exempt organizations, churches are excluded from filing Form 990 in certain circumstances.
Regardless, many churches still choose to file with the IRS to have official recognition of their tax-exempt status. Churches also want to be listed under the IRS as having tax-deductible donations as a qualified charitable organization.
Tax-exemption also doesn’t mean that a church is excluded from paying taxes. They are still responsible for paying specific employment taxes and taxes on unrelated business income.
Unrelated Business Income Taxes
Nonprofit organizations and churches do not have to pay income taxes on unearned income. This guideline includes donations, grants, gifts to the organization, and investment income. However, they are still subject to income taxes on unrelated business income for the profits they earn.
This tax is called the unrelated business income tax (UBIT). Churches who earn an unrelated business gross taxable income of $1,000 or more in a tax year must file Form 990-T, Exempt Organizations Business Income Tax Return, for that tax year. Income earned from thrift shops, volunteer work, donor lists, low-cost giveaways, and advertising is not subject to UBIT. For income to be classified as UBIT, the activity must:
- Constitute a trade or business
- Be regularly carried on
- Not be substantially related to the church’s exempt purpose
UBITs can also hurt a church’s tax-exempt status. Generally, if more than 15 percent of the religious group’s total earnings come from unrelated business income, the organization is at risk of losing its tax-exempt status. There are two exceptions for UBITs, though:
- If “substantially all” of the labor for the trade or business is provided by volunteers.
- If “substantially all” of the merchandise sold was donated to the organizations, e.g., bake sales and thrift stores.
Do Church Employees Pay Taxes?
If you work for a church, do you pay taxes? The simple answer is yes; paid church employees are considered employees by the IRS for income tax purposes.
But what payroll taxes do churches pay, exactly? Churches are required to withhold income taxes from employees who are not ministers, and their income should be reported on a Form W-2 just like an employee in any other industry. Churches are exempt from paying federal unemployment taxes for all employees.
The answer to the question, “do churches pay payroll taxes,” is more complicated when it comes to ministers, pastors, and clergy members. Most ministers have a dual tax status. Their ministerial income qualifies them as self-employed for Social Security purposes, and they are considered church employees for income tax purposes.
Do Churches Pay Payroll Taxes for Pastors?
Churches are not required to withhold income taxes from ministers, even if they are considered an employee. However, churches should still issue ministers a Form W-2, even though they are considered self-employed because of their dual tax status.
Church Employees and Federal Income Taxes
Do church employees pay income tax? Yes, churches must withhold income taxes from employee wages. However, clergy employees are treated differently due to their dual tax status. For state and federal government taxes, clergy employees are considered employees, while also regarded as self-employed for social security and medicare taxes.
This dual status means that ministers are still responsible for quarterly estimated self-employment tax payments (SECA) due to their self-employment status. For federal income taxes, churches are responsible for withholding applicable taxes (if any) from a minister’s wages and reporting those withholdings on their Form W-2.
However, if a clergyperson enters a voluntary withholding agreement with the church, the organization would withhold income taxes and estimated self-employment taxes. By voluntarily withholding taxes, the minister eliminates the need to make estimated tax payments and is considered on time for both income and self-employment tax payments. This agreement can be terminated at any time by either party.
By doing this, late payment penalties for quarterly estimated taxes are avoided as the amount withheld is used as a credit for both federal income taxes and the self-employment tax for a minister’s income tax return. Should a church enter this agreement with their minister, they would need to report the amounts on their Form 941 as additional taxes withheld and not as Social Security or Medicare taxes.
Church Employees and FICA (Social Security and Medicare)
Churches are required to pay Social Security and Medicare taxes for non-clergy employees in addition to withholding federal income from their wages, according to the Federal Insurance Contributions Act (FICA).
Do Church Employees Pay Social Security Taxes?
Because clergy employees are generally considered self-employed, churches are not responsible for minister FICA tax obligations. The 7.65% FICA tax and Social Security and Medicare taxes are not withheld from a minister’s pay, and boxes 3, 4, 5, and 6 on their Form W-2 are left blank. Ministers are still responsible for paying the 15.3% SECA tax.
Suppose specific public insurance policies go against the religious beliefs of the church. In that case, ministers can file Form 4361 with the IRS to be exempt from self-employment taxes for their ministerial earnings. File this form by the income tax return due date for the second tax year in which a minister’s net earnings from self-employment is at least $400. These two years do not have to be consecutive, and the rule only applies if the net earnings came from performing ministerial services.
Once the IRS grants the exemption, the decision is irrevocable. An example of this is when ministers choose whether to opt-out of Social Security. Once they opt out of Social Security, they cannot opt back in.
Housing Allowances Can Impact Church Employees’ Taxes
Housing allowances are challenging to understand, even for tax professionals. Housing allowances (also known as parsonages or rental allowances) that are part of a minister’s salary can be excluded from their gross income. Parsonages are not excluded from SECA taxes, so exclude them from a minister’s gross income for income taxes.
Housing allowances must be designated before they are paid out and used in the year the allowance is specified. Additionally, more than what was designated cannot be claimed on a tax form.
The amount used to provide the home and the home’s fair market rental value can be exempt from a clergy employee’s gross income. This value includes furnishings, utilities, and the other appurtenances of a home. All expenses related to maintaining and running a household can be housing allowance deductions.
The IRS does provide requirements for ministers that qualify for housing allowance. However, the church determines which of its clergy employees are qualified to perform these essential functions:
- Ministers must have the ability to perform sacerdotal functions.
- Ministers must be considered essential to the overall worship experience.
- Ministers must be recognized by a board resolution and have written documentation
What About Independent Contractors Compensated by the Church?
The first step is to determine if the worker qualifies as an independent contractor by the IRS. Here are the questions to ask to determine proper classification:
- Does the company control or have the right to control what the worker does and how they perform their job?
- Are the business aspects of the worker’s job controlled by the payer?
- Are there written contracts or employee type benefits (e.g., pension plan, insurance, vacation pay, etc.)?
- Will the relationship continue, and is the work performed a vital aspect of the business?
Examples of independent contractors include guest speakers, guest musicians, pulpit supply, repair workers, lawn care services, and cleaning services. Churches do not need to send copies of 1099s to other churches, nonprofit organizations, S or C corporations, or contractors paid electronically.
If a worker is considered an independent contractor by the church, the worker must complete Form W-9, Request for Taxpayer Identification Number and Certification. Churches need to keep a copy of the Form W-9 for at least four years in the event of an IRS audit. It’s also essential for religious organizations to keep a Form W-9 for paid guests and contractors, even though they are not required to file a Form 1099.
Starting in 2020, a church will need to complete Form 1099-NEC, Nonemployee Compensation for independent contractors. The information on this form was previously reported on box 7 of Form 1099-MISC. The new Form 1099-NEC reports payments in excess of $600 for services completed by nonemployees.
Copies of the form must be submitted to the IRS and sent to the independent contractor. Both documents must be submitted by January 31 of the year following payment.
If a church considers a worker to be an independent contractor, but the IRS reclassifies that worker as an employee, the church is liable for hefty fines. This type of error is why having an HR partner who understands payroll tax complexities is essential. They can help an organization better comprehend how to classify workers.
How APS Can Streamline Your Church Payroll
It’s easy to see why church payroll taxes are so complicated and why it’s crucial to manage church employees and taxes correctly. The two biggest questions we answered were:
- Do churches pay employment taxes?
- Do employees of churches pay taxes?
The answer is the same for both of these questions. Yes, but it depends on the church employee and their duties. That’s why you need a payroll and HR partner who understands the complexities of payroll tax compliance for churches. Since 1996, we’ve worked closely with churches to provide the tax compliance expertise they need. We’ve learned the biggest frustrations that religious organizations face are:
- Their previous payroll partner was unable to report and deduct housing allowances for their ministers accurately.
- They are burdened with inaccurate tax reporting and filing for tax-exempt incomes versus UBITs.
- They struggle with employee classifications for clergypeople versus the rest of their workforce and the tax deductions associated with those employee types.
At APS, we can help you not only keep track of parsonages and minister taxes for both dual tax statuses, but we can also help you track employee time across multiple campuses with multiple pay rates. This way, you’re accurately tracking which employee to pay and which deductions those workers receive. This way, you avoid penalties from the IRS during tax season, and you maintain your tax-exempt status.
If you’re a Sage Intacct user, our automated integration with their general ledger allows for dimension tracking. You can accurately allocate grants and funds to the proper groups of employees, even across multiple campuses.
To learn more about how APS helps churches contact us at 855-974-7921.
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