Now we know that whatever the law says, it speaks to those who are under the law, so that every mouth may be silenced, and the whole world may be held accountable to God.
Romans 3:19 (NRSV)
Why are professional expenses part of clergy compensation? The answer to this question goes back to the time when clergy were considered self-employed in all respects. Today, clergy are considered self-employed for purposes of social security taxes and employed by their local church for purposes of Federal and state income taxes. However, when clergy were considered self-employed only, it was common for churches to budget an amount separate from base salary to help the pastor with his or her out-of-pocket professional expense.
The most common type of clergy professional expense is travel. Other types of professional expenses may include: computers, office supplies, postage, books, subscriptions, professional dues, vestments, and continuing education (if not treated as a separate component of compensation). In addition, there may be other examples of professional expenses based on the specific facts and circumstances at a local church.
There are many expenses that should not be considered professional expenses. These expenses typically include: mileage for commuting between church and home, spousal travel, vacations, expenditures related to researching or publishing a book or article (other than in a local church newsletter), everyday clothing, medical expenses, child care/dependent expenses, insurance premiums (life, disability, and medical), charitable contributions, and housing related expenses. Some of these expenses may be payable by a local church in other ways, but not as professional expenses.
Clergy compensation that is designated for professional expenses must be separated between allowance amounts and accountable reimbursement amounts. The pastor may request that the professional expense amount be treated entirely as an allowance amount, entirely as a reimbursement amount, or a combination of an allowance amount and a reimbursement amount. The allowance and accountable reimbursement methods of paying for professional expenses have different features.
The allowance method may be the easiest method to administer, but may not be the best method from a tax perspective. Under the allowance method, professional expense amounts must be paid to the pastor during the year according to the church’s payroll cycle (bi-weekly, monthly, etc.). The pastor is not required to provide the church with receipts since the Internal Revenue Service (IRS) considers the allowance method a nonaccountable plan.
Professional expense amounts paid as an allowance are taxable and must be reported as wages in Box 1 of the pastor’s Form W-2 at the end of the year. (Pastors may be able to deduct some of their professional expenses on their tax returns depending on their personal tax situation.)
Churches should avoid changing from the allowance method to the accountable reimbursement method at the end of the year. Problems associated with waiting until year-end to adopt the reimbursement method may include: (1) the likelihood that proper documentation to account for certain expenses may no longer be possible, (2) the inability to account for professional expenses within a reasonable period of time based on IRS guidelines, (3) the need for the pastor to repay any amount paid in excess of actual expenses, and (4) improper reporting of compensation on the Pastor’s Compensation Profile report that was used to calculate pension contributions.
The accountable reimbursement method is exactly that – a reimbursement of actual expenses incurred. Under the reimbursement method, pastors must account for their expenses and obtain reimbursement by submitting periodic expense reports (including receipts) to the local church. Reimbursements are not taxable and should not be reported on Form W-2.
Any reimbursements or advances in excess of actual expenses should be repaid to the church within a reasonable period of time. In general, churches should refrain from giving their pastor any unused reimbursement amounts at the end of the year to avoid the possibility of the entire reimbursement amount being treated as an allowance amount.
Ideally, reimbursement amounts should be established at the beginning of the pastor’s appointment to the church because it is likely that the IRS will not allow a church to subsequently create or increase an accountable reimbursement amount by reducing the pastor’s base salary. However, local churches may create or increase the pastor’s reimbursement amount by increasing the pastor’s total compensation.
Note that computers and other tangible goods paid for under the reimbursement method actually belong to the church. Churches may later offer to sell these items to the pastor at fair market value or churches may choose to treat these items as a gift to the pastor. If considered a gift, these items are taxable to the pastor based on the current fair market value.