Table of Contents

BY RICHARD R. HAMMAR

A federal appeals court has ruled that for federal income tax reporting purposes an Assemblies of God minister was self-employed rather than an employee. This article will review the facts of the case, summarize the court's decision, and address the significance of the case to other ministers and churches.

FACTS

James Alford, an ordained Assemblies of God minister, served as pastor of an Assemblies of God church in Hampton, Arkansas, for several years. He reported his income taxes as self-employed while serving as pastor of the church. The IRS audited three of Rev. Alford's tax returns and determined that he should have reported his income taxes as an employee rather than as self-employed. This reclassification resulted in additional taxes.

Rev. Alford paid the taxes under protest and then sued the government in a federal court in Arkansas, seeking a refund. The court agreed with the IRS that Rev. Alford was an employee and that the IRS had correctly assessed the additional taxes.

THE APPEALS COURT'S RULING

Rev. Alford appealed the court's ruling to a federal appeals court which reversed the lower court's decision and concluded that for income tax reporting purposes Rev. Alford was self-employed rather than an employee. As a result, it ordered the IRS to refund to Rev. Alford the additional taxes he paid because of the erroneous decision by the IRS that he was an employee.

In deciding whether Rev. Alford, for federal income tax reporting purposes, was an employee or self-employed, the court applied a 12-factor test developed by the United States Supreme Court. These factors are summarized in Table 1.

TABLE 1.-U.S. Supreme Court 12-factor test

Factor	Explanation
1. The hiring party's right to control the manner and means by which the product is accomplished-	Indicates a worker is an employee.
2. The skill required-	The more skill that is required, the more likely a worker is self-employed.
3. The source of the instrumentalities and tools-	Workers who provide their own are more likely self-employed.
4. The location of the work-	If the work occurs on the employer's premises, this indicates the worker is an employee.
5. The duration of the relationship between the parties-	The longer the relationship, the more likely a worker is an employee.
6. Whether the hiring party has the right to assign additional projects to the hired party-	Indicates a worker is an employee.
7. The extent of the hired party's discretion over when and how long to work-	The more discretion, the more likely the worker is self-employed.
8. The method of payment-	Employees are paid by the hour or week; self-employed workers are paid by the job.
9. The hired party's role in hiring and paying assistants-	Self-employed workers hire and pay their own assistants; employees do not.
10. Whether the work is part of the regular business of the hiring party-	An employee's work is part of the regular business of the employer.
11. Whether the hiring party is in business-	Employers are more likely to work for organizations that provide services or products to the public.
12. The provision of employee benefits-	Employees are more likely to receive fringe benefits.

The appeals court concluded, on the basis of this 12-factor test, that Rev. Alford was not an employee of the local church he served. It acknowledged that the following facts suggested that Rev. Alford was an employee of his church: (1) his salary (though not based on percentage of church income) was dependent on church revenue; (2) the church paid several fringe benefits, including a portion of his self-employment tax, a housing allowance, and health insurance; (3) the church provided him with a credit card to purchase gasoline; (4) the church provided him with an annual Christmas gift; and (5) the church made available a desk, chair, and copy machine.

On the other hand, the court concluded that the following additional facts demonstrated that Rev. Alford was self-employed: (1) he provided most of his own furniture; (2) he used his own car, computer, and library in the performance of his duties; (3) he set his own schedule; (4) he was free to perform weddings, funerals, and revivals for a fee and was not required to pay over any of the fees to the church; (5) he was not expected to pay for a substitute pastor if one was necessary; and (6) he arranged for evangelists or special speakers and contributed to special collections taken for them.

RELEVANCE OF THE CASE TO OTHER MINISTERS AND CHURCHES

What is the significance of this important ruling to other ministers and churches? Consider the following:

1. Continued confusion. The Alford case will insure that the correct reporting status of ministers for income tax purposes will remain ambiguous.
2. "Dual tax status."
   
   Most of the confusion associated with clergy tax preparation is based on the fact that clergy have a "dual tax status." For federal income tax reporting purposes most clergy are employees, but for social security purposes all clergy are self-employed (with respect to services performed in the exercise of ministry). Many church treasurers assume that ministers who are treated as employees for income tax purposes must be treated as employees for social security purposes. They accordingly withhold FICA taxes from the wages of their ministers just as they would for a nonminister church employee. While common, this approach is incorrect. All ministers are self-employed for social security purposes with respect to their ministerial services. As a result, they pay the self-employment tax, not FICA taxes. This is so even if, for income tax reporting purposes, the ministers are employees.
3. The Supreme Court's 12-factor test.
   
   In deciding whether or not, for federal income tax reporting purposes, Rev. Alford was an employee or self-employed, the court relied on a 12-factor test developed by the United States Supreme Court (see Table 1). Ministers are free to use this test in determining their own status for income tax reporting purposes.
4. What difference does it make?
   
   What difference does it make whether a minister or other church staff member is an employee or self-employed? Consider the following:
   
   a. Reporting compensation.
   
   Employees report their compensation directly on Form 1040 (line 7-wages) and deduct unreimbursed (and "nonaccountable" reimbursed) business expenses on Schedule A, only if they itemize deductions and only to the extent that such expenses exceed 2 percent of adjusted gross income. Self-employed persons report compensation and business expenses on Schedule C. Business expenses are in effect deductible whether or not the minister itemizes deductions and are not subject to the 2 percent floor.
   
   b. Adjusted gross income.
   
   Adjusted gross income ordinarily will be higher for persons who report their federal income taxes as an employee, since unreimbursed (and "nonaccountable" reimbursed) business expenses are deductions from adjusted gross income. Self-employed persons deduct business expenses in computing adjusted gross income. Adjusted gross income is a figure that is important for many reasons. For example, the percentage limitations applicable to charitable contributions and medical expense deductions are tied to adjusted gross income.
   
   c. W-2 or 1099?
   
   Persons working for a church or church agency should receive a Form W-2 each year if they are employees and a Form 1099-MISC if they are self-employed (and receive at least $600 in compensation).
   
   d. Tax-deferred annuities.
   
   Nonprofit employers, including churches, can offer "tax-deferred annuities" (also known as "403(b) annuities") to their employees. These are a popular form of retirement program for many churches. These annuities are available to ministers whether they report their income taxes as employees or as self-employed. However, they are not available to nonminister church staff who are self-employed.
   
   e. Tax treatment of various fringe benefits.
   
   Certain fringe benefits provided by a church on behalf of a worker are nontaxable only if the worker is an employee. Examples include medical insurance premiums paid by a church on behalf of an employee; group term life insurance (up to $50,000) provided by a church on behalf of an employee; amounts payable to employees on account of sickness, accident, or disability pursuant to an employer-financed plan; and employer-sponsored "cafeteria plans" which permit employees to choose between receiving cash payments or a variety of fringe benefits.
   
   f. Audit risk.
   
   Self-employed persons face a much higher risk of having their tax returns audited. Why? IRS data reveals that the "voluntary reporting percentage" (i.e., persons who voluntarily report the correct amount of income) is 99.5 percent for employees covered by mandatory income tax withholding but is only 13 percent for persons not covered by mandatory withholding and for whom no 1099 or W-2 forms are filed. As a result, the IRS scrutinizes the tax returns of self-employed persons (who are not subject to tax withholding) much more closely than those of employees.
   
   g. Consequences of being reclassified as an employee.
   
   Persons who report their income taxes as self-employed face a significant risk of additional taxes and penalties if they are audited by the IRS and reclassified as employees. This is because many persons who report their income taxes as self-employed deduct unreimbursed (and "nonaccountable" reimbursed) business expenses as a deduction on Schedule C. If they are reclassified by the IRS as employees, their business expense deduction will be allowable only as an itemized deduction on Schedule A, and then only to the extent that the expenses exceed 2 percent of adjusted gross income. Persons who are not able to itemize end up with no deduction for their business expenses. This can result in a substantial increase in taxable income.
   
   h. Housing allowances.
   
   A minister's eligibility for a housing allowance is not affected by his or her tax reporting status. Employees and self-employed ministers are eligible for this benefit.
   
   i. Miscellaneous.
   
   Persons who are, for federal income tax reporting purposes, employees are more likely to be deemed employees for purposes of other laws, including the following: (1) workers compensation; (2) minimum wage and overtime; (3) Title VII of the Civil Rights Act of 1964 (which prohibits covered employers from discriminating in any employment decision on account of an employee's race, color, national origin, gender, or religion); (4) the Age Discrimination in Employment Act (which prohibits covered employers from discriminating in any employment decision on account of an employee's age-if 40 years of age or older); (5) the Americans with Disabilities Act (which prohibits covered employers from discriminating in any employment decision on account of an employee's disability); and (6) state civil rights laws.
   
   
5. Advantages of employee status. Some ministers will find it easier to defend self-employed status on the basis of the Alford case. However, this should not cause ministers who report their income taxes as employees to change their status to self-employed, nor should it keep self-employed ministers from changing to employee status. The simple fact is that in the vast majority of cases ministers will be better off for federal tax purposes by reporting as employees rather than as self-employed. The advantages of employee status include:
   • The value of various fringe benefits will be nontaxable, including the oftentimes significant cost of employer-paid health insurance premiums on the life of the minister and his or her dependents.
   • The risk of an IRS audit is substantially lower.
   • As an employee, a minister and his or her employing church avoid the additional taxes and penalties that may apply in the event a self-employed minister is audited by the IRS and reclassified as an employee.

The only "advantages" of self-employed status are that business expenses are deductible whether or not the minister is able to itemize deductions on Schedule C, and these expenses are not subject to the 2 percent "floor" that applies to employee business expenses (deductible only to the extent they exceed 2 percent of adjusted gross income). However, employees can realize the same benefits by having their employing church adopt an accountable business expense reimbursement policy.

Richard R. Hammar, J.D., LL.M., CPA, serves as legal counsel to The General Council of the Assemblies of God. A graduate of Harvard Law School, he is the author of over 30 books on legal and tax issues for churches and pastors. This article is excerpted from his Church, Law, & Tax Report newsletter.