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The Lutheran church's understanding of call is that the congregation and pastor or associate in ministry enter into a "continuing mutual relationship and commitment." This is a special relationship in which the pastor or AIM is called by God through the congregation. Therefore, the pastor or AIM is not a hireling, but rather a partner in the ongoing ministry of the congregation.

At the same time, it is necessary to determine the employment status of a pastor or associate in ministry as it relates to the laws of the country, and in particular, the tax laws and regulations. Whether or not a pastor or nonordained staff member is an employee or self-employed is an important question. Unfortunately, it also can be a complex and at times confusing question. This section will address this question on the basis of the most recent legal precedent.

The focus of this section will be on the correct reporting status of pastors and nonordained staff members for federal income tax reporting purposes. The correct reporting status of these individuals for social security purposes is also addressed in this section, but this issue occupies much less attention. The reason is simple--pastors always are treated as self-employed for purposes of social security with respect to services they perform in the exercise of their ministry. The difficulty in determining the correct reporting status of pastors therefore is associated with income tax reporting, and not social security. Similarly, for nonordained staff members, their reporting status for federal income tax purposes generally determines their reporting status for social security. In summary, the focus of this section will be on the correct reporting status of pastors and nonordained staff members for income tax purposes.

In Summary:
Reporting income taxes as an employee. Most clergy should report their federal income taxes as employees, because they will be considered employees under the test currently used by the IRS. Most clergy will be "better off" reporting as employees, since (1) the value of various fringe benefits will be excludable, including the cost of employer-paid health insurance premiums on the life of the pastor, (2) the risk of an IRS audit is substantially lower, and (3) reporting as an employee avoids the additional taxes and penalties that often apply to self-employed clergy who are audited by the IRS and reclassified as employees.

Pastors have a "dual tax status." While most pastors are employees for federal income tax reporting purposes, they all are self-employed for social security purposes (with respect to services they perform in the exercise of their ministry). This means that pastors are not subject to "FICA" taxes, even though they report their income taxes as employees and receive a W-2 from their church. Rather, they pay the "self-employment tax."

Nonordained church workers. The IRS and the courts will apply the same tests used in determining the correct reporting status of pastors to determine the reporting status of nonordained church workers for income tax reporting purposes.

Tests for determining employee status. There are at least 3 recognized tests for determining whether a pastor or lay worker is an employee or self-employed for federal income tax reporting purposes. These include: (1) the "common law employee" test set forth in the income tax regulations; (2) the 20-factor test announced by the IRS in 1987; and (3) the 7-factor test announced by the United States Tax Court in 1994 in 2 cases addressing the correct reporting status of pastors.

The question of whether a pastor should report his or her federal income taxes as an employee or as a self-employed person is one that has generated a good deal of controversy. It is a significant question for many reasons, including the following:

(1) 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% of adjusted gross income (only 50% of business meals and entertainment expenses are counted). Self-employed persons report compensation and business expenses on Schedule C. Business expenses are in effect deductible whether or not the pastor itemizes deductions, and are not subject to the 2% floor.

(2) Adjusted gross income. Adjusted gross income ordinarily will be higher if a pastor reports 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.

(3) W-2 or 1099? Pastors 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).

(4) Tax-deferred annuities. Favorable "tax-deferred annuities" (also known as "403(b) annuities") offered by nonprofit organizations (including churches) may only be available to employees.

(5) Tax treatment of various fringe benefits. Certain fringe benefits provided by a church on behalf of a pastor are excludable from the pastor's income only if he or she is an employee. Examples include medical insurance premiums paid by a church on behalf of its pastor; group term life insurance (up to $50,000) provided by a church on behalf of a pastor; amounts payable to employees on account of sickness, accident, or disability pursuant to an employer-financed plan; employer-sponsored "cafeteria plans" which permit employees to choose between receiving cash payments or a variety of fringe benefits.

(6) Audit risk. Self-employed persons face a much higher risk of having their tax returns audited. IRS data reveals that the "voluntary reporting percentage" (i.e., persons who voluntarily report the correct amount of income) is 99.5% for employees covered by mandatory income tax withholding, but is only 13% 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. It is also relevant to note that the IRS has been concerned for a number of years with the problem of persons reporting their income taxes as self-employed when in fact they are more properly characterized as employees. The IRS and General Accounting Office conducted a joint study to determine whether 1099-MISC forms (annual information returns issued to self-employed workers) may reveal workers more properly classified as employees. The study revealed a "universe" of self-employed persons who received all of their business income (reported on Schedule C of Form 1040) from a single employer. The IRS is in the process of determining whether such a relationship is an indication of a misclassification of employees as self-employed. This is a significant issue for clergy, many of whom continue to report their federal income taxes as self-employed. In many cases, all of the Schedule C earnings of such clergy are attributable to their employing church, and are reported on a single 1099-MISC form. The IRS study concluded that the receipt of a single 1099-MISC form reporting self-employment income from a single source indicates that a worker is improperly reporting his or her federal income taxes as self-employed. As a result, self-employed clergy may wish to re-evaluate their status for federal income tax reporting purposes.Internal Revenue Manual update MT 5(10)00-2.

(7) Consequences of being reclassified as an employee. Clergy who report 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 clergy who report as self-employed deduct their 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% of adjusted gross income. Clergy 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.

The primary disadvantage of employee status is that most business expenses are deductible only as itemized deductions on Schedule A (i.e., the pastor must be able to itemize deductions in order to deduct them), and they are deductible only to the extent that they exceed 2% of adjusted gross income. This "disadvantage" can be overcome simply by having your employing church adopt an accountable reimbursement policy under which the church reimburses you for those business expenses that you periodically substantiate.

Selecting the correct status--3 tests
For many years, most pastors reported their income taxes as self-employed persons. This was consistent with the treatment of all pastors as self-employed for social security purposes (with respect to services performed in the exercise of ministry). However, it is important for clergy to realize that they have a "dual" tax status--they are considered self-employed for social security purposes (they pay the self-employment tax rather than FICA taxes), but they may be employees or self-employed for federal income tax purposes depending upon a variety of circumstances outlined below.

Beginning in 1978, the IRS began making statements that were interpreted by some to require pastors to report their income taxes as employees. For example, in Revenue Ruling 80-110, the IRS held that a pastor who is "an employee of a church" may not deduct unreimbursed business expenses on Schedule C but rather must use Schedule A. See also Revenue Ruling 79-78. In Publication 517 ("Social Security for Members of the Clergy and Religious Workers"), the IRS lists a comprehensive example demonstrating how a pastor who is "an employee of the church" should report his income and business deductions. These pronouncements led some tax advisors to conclude that the IRS now views all pastors serving local churches as employees rather than as self-employed. Reliance has also been placed on section 3401(a)(9) of the Internal Revenue Code which states that pastors who are employees of a church are exempt from tax withholding.

The IRS and the courts generally apply either or both of three tests in deciding whether a particular worker is an employee or self-employed for income tax reporting purposes -- (1) the so-called common law employee test, (2) the "20 criteria test" adopted by the IRS in 1987, or (3) the "7 factor test" announced by the United States Tax Court in 1994. Since the 20 criteria and 7 factor tests are amplifications of the common law employee test, for clarity only the common law test is explained in the paragraphs that follow.

The "common law employee" test
The best approach to this issue is to treat pastors as employees only if they satisfy the common law employee test adopted by the Treasury Department:

Generally the relationship of employer and employee exists when the person for whom services are performed has the right to control and direct the individual who performs the services, not only as to the result to be accomplished by the work but also as to the details and means by which that result is accomplished. That is, an employee is subject to the will and control of the employer not only as to what shall be done but how it shall be done. In this connection, it is not necessary that the employer actually direct or control the manner in which the services are performed; it is sufficient if he has the right to do so. The right to discharge is also an important factor indicating that the person possessing that right is an employer. Other factors characteristic of an employer, but not necessarily present in every case, are the furnishing of tools and the furnishing of a place to work to the individual who performs the services. In general, if an individual is subject to the control or direction of another merely as to the result to be accomplished by the work and not as to the means and methods for accomplishing the result, he is not an employee. Generally, physicians, lawyers, dentists, veterinarians, contractors, subcontractors, public stenographers, auctioneers, and others who follow an independent trade, business, or profession, in which they offer their services to the public, are not employees. Treas. Reg. 31.3401(c)-1(b)-(c). See also Publication 517.