Article Highlights: Internal Revenue Code Section 107 Court Ruling Employee Status Self-employed Status Parsonage Allowance Self-employment Tax Exemption from Self-employment Tax If you read our previous article related to a Wisconsin District Court ruling, you will recall that the judge in that case had ruled that Sec. 107(2) of the Internal Revenue Code was unconstitutional. Section 107 of the Internal Revenue Code provides that a minister’s gross income doesn’t include the rental value of a home provided by the house of worship. If the home itself isn’t provided, then a rental allowance paid as part of compensation for ministerial services is excludable. This benefit is generally referred to as a parsonage allowance. Thus, a minister can exclude the fair rental value (FRV) of the parsonage from income under IRC Sec. 107(1), or the rental allowance under Sec. 107(2), for income tax purposes. The Sec. 107(2) rental allowance is excludable only to the extent that it is for expenses such as rent, mortgage payments, utilities, repairs, etc., used in providing the minister’s main home, and only up to the amount of the home’s FRV. Good news for clergy members: a 3-judge panel of the 7th U.S. Circuit Court of Appeals has unanimously overturned the lower court’s decision and ruled that Sec. 107 is constitutional; therefore, housing allowances continue to be excludable from income tax. It is unknown whether those who brought the suit will ask the full 7th Circuit to review the case or appeal it to the U.S. Supreme Court and, if so, whether the Supreme Court will take it up. Here is an overview of how members of the clergy (from all faiths) are taxed on their income. When we refer to “church” in this article, please read that to include mosques, synagogues, temples, etc. Members of the clergy are taxed on not just their salary but on other fees and contributions that they receive in exchange for performing services such as marriages, baptisms, funerals, and masses. As a result, clerics will generally report their income in two ways: As an Employee – As an employee, clerics will receive a W-2 from the church showing the amount of their income that is subject to tax, any amount paid as a nontaxable housing allowance (discussed later), and any withholding. Any expenses incurred as a W-2 employee are included on Form 2106 (Employee Business Expenses) and if the cleric also receives a nontaxable parsonage allowance, the expenses must be divided between the taxable W-2 income and nontaxable parsonage allowance. Unfortunately, for years 2018 through 2025 the deduction for employee business expenses has been suspended by tax reform. The suspension affects all employee business expenses, not just those of clergy employees. As a Self-Employed Individual – Income received other than as an employee of a church is reported as self-employment income. Typically, this would include all income that is not included in the W-2 from the church, including fees charged for services, such as weddings, funerals, and other gatherings. This income and any expenses associated with it are reported on Schedule C and are subject to the self-employment tax. Parsonage Allowance – As was discussed previously, as the subject of the court ruling, a member of the clergy can qualify to have a rental allowance excluded from his or her taxable income if that allowance is provided as remuneration for services that are ordinarily the duties of a minister of the gospel. The following are the qualifications and details of the parsonage allowance: It is only excludable to the extent that it is used for expenses related to the minister’s housing (e.g., for rent, mortgage payments, utilities, and repairs). The rental allowance is not excludable to the extent that it exceeds reasonable compensation for the minister’s services. The allowance only applies to the minister’s primary residence. The allowance cannot exceed a home’s FRV, including furnishings and appurtenances such as garages, plus the cost of utilities. In advance of the payment, the employing organization must designate the allowance by an official action. If a minister is employed by a local congregation, the designation must come from the local church, instead of from the church’s national organization. The portion of the minister’s business expenses that is attributable to tax-free income is not deductible. This rule does not apply to home-mortgage interest or to taxes that are deductible in full if the minister itemizes deductions. Retired clerics can exclude a home’s rental value or a rental allowance if the home is furnished as compensation for past services and authorized under a convention of a national church organization. However, this exclusion does not extend to the widow or widower of a retired cleric.