If you have a minister, priest or other member of the clergy as a client, you face some interesting challenges. Special tax laws apply to clergy, and even the tax courts and the Internal Revenue Service have interpreted them differently over the years. In addition, it seems that nearly every congregation has its own take on applying the rules, is adamant that its interpretation is correct and is unwilling to change.

Clergy's tax status offers unique planning opportunities for savvy clients and potentially costly pitfalls for unwary ones. Financial planners who have clergy for clients must school themselves in this quirky part of the tax code in order to help clerics make the most of their status.

DUAL TAX STATUS

For tax purposes, most workers are classified as either employees or self-employed. Clergy, however, are both. For federal income tax purposes, the IRS in nearly all cases considers clergy to be employees. On the other hand, clergy are not subject to Social Security and Medicare taxes, even though they receive a W-2 from their congregation. Instead, clergy pay self-employment tax. This dual tax status is the source of both the opportunities and the pitfalls for clergy members and their planners.

Most clergy are better off reporting their federal income taxes as employees for several reasons:

• The value of certain fringe benefits is excluded, including employer-paid health insurance premiums, group term life insurance and contributions to retirement plans.
• Clergy can be reimbursed by their congregations for business expenses without any income tax consequences, as long as the reimbursements are through an "accountable plan."
• Self-employed individuals have a higher risk of being audited than employees. If they are audited and reclassified as employees, they will be subject to penalties and additional taxes.

Being classified as an employee for federal income tax purposes does have its downside, however. For example, unreimbursed business expenses are subject to a floor of 2% of adjusted gross income (AGI) and must be reported on Schedule A.

Whether clergy are classified as employees or as self-employed, they are exempt from federal tax withholding. However, clergy who are considered employees can request that their income taxes and self-employment taxes be withheld from their salary payments-a strategy I recommend. Otherwise, clergy must make quarterly estimated payments for federal income taxes and self-employment taxes to avoid underpayment penalties.

THE HOUSING QUESTION

Another source of opportunity and pitfalls involves parsonage. Parsonage is the tax rule that allows clergy to exempt from their federal income taxes a portion of salary that's earmarked for housing costs. Nearly 100 years old, parsonage originated when many congregations provided housing to attract clergy to their communities. This exemption has broadened over the years to where today, clergy can exempt the annual rental value of their home from their taxable income, even if they own the home themselves.

In 2002, the Ninth Circuit Court debated the constitutionality of parsonage. Because of that case, Congress passed the Clergy Housing Allowance Clarification Act of 2002, which President Bush signed into law. The act clarified the constitutionality of parsonage and also made clear that a parsonage allowance is now limited to the fair rental value of the home. (Previously, the parsonage value was determined using any one of three tests.)

The parsonage amount is not a deduction from a clergy member's income. It's just not reported as income. The rules do differ depending on whether the clergy is receiving parsonage (if the house is congregation-owned) or a housing allowance (house is owned by the clergy member). For simplicity's sake, however, I use the two interchangeably in this article.

Many clergy fail to take full advantage of the law when determining the correct amount of parsonage, and this is an area where financial planners can be of great service. Parsonage not only includes maintenance and upkeep of the house, but also its contents, the property and the garage. It does not include domestic help or food. Any parsonage amount that exceeds actual usage is reported as taxable income.

Some clergy have told me they've been warned that there is a limit as to how much parsonage can be designated. But as long as the declared amount can be verified (using receipts, etc.), there is no dollar or percentage ceiling. Some clergy clients insist on using a lower figure than they are entitled to because they are uncomfortable declaring a parsonage amount that may represent almost their entire salary. That's a personal decision, not a determination based on the statutes.

The IRS requires the congregation to follow specific procedures to authenticate the part of a cleric's income designated as parsonage. Failure to comply can leave both the congregation and the clergy open to fines during an audit. The parsonage amount can be modified as circumstances dictate, as long as these procedures are followed. A financial planner can help ensure that the procedures are followed correctly.