Pastors are considered “dual-status” employees for tax purposes, which means they are treated as employees for federal income tax purposes but as self-employed for Social Security and Medicare purposes. Here’s a detailed breakdown of how clergy compensation is handled, including important caveats for proper reporting on W-2 forms and Form 941:
1. Housing Allowance
•Not Included in Box 1 Wages: A minister’s housing allowance, whether designated for cash payment or housing expenses, is not taxable for federal income tax purposes and is not reported in Box 1 of the W-2.
•Optional Reporting in Box 14 or Separate Statement: Churches often list the housing allowance in Box 14 of the W-2 for informational purposes, but they may also provide a separate statement to the pastor.
•100% Salary Exclusion: Pastors may elect to have up to 100% of their salary designated as a housing allowance. In this case, nothing is reported on the W-2 regarding the housing allowance; it must be documented in a church resolution and detailed in a separate statement provided to the minister.
•Subject to Self-Employment Tax: The housing allowance is still subject to self-employment tax and must be included in the pastor’s calculation of SECA tax.
2. Accountable Reimbursement Plans
•Not Included in Box 1 Wages: Reimbursements made under an accountable plan (e.g., for ministry-related expenses such as mileage, travel, or supplies) are not taxable income. To qualify:
•The pastor must provide proper documentation, such as receipts, invoices, or mileage logs.
•Any unused advances must be returned to the church.
•Non-Accountable Reimbursements: Reimbursements made without accountability (no documentation or substantiation) are considered taxable income and must be included in Box 1 of the W-2.
3. Federal and State Withholding
•No Social Security/Medicare Withholding: Pastors’ wages are exempt from FICA (Social Security and Medicare withholding), and the W-2 should reflect:
•No amounts in Boxes 3, 4, 5, or 6 (Social Security/Medicare wages and taxes).
•Voluntary Withholding: Pastors can elect voluntary withholding for federal and state income taxes, which can also cover their self-employment tax liability. This is done by submitting Form W-4 to the church.
•Self-Employment Tax Reimbursements: If the church reimburses the pastor for half of their self-employment tax, this reimbursement is considered taxable income and must be included in Box 1 of the W-2.
4. Form 941 Reporting
•Mark Box 4 if All Employees Are Exempt: If the pastor is the only church employee, make sure to check Box 4 (“No wages subject to Social Security/Medicare tax”) on Form 941. This confirms that no employees are subject to FICA, including Social Security and Medicare taxes.
•No Social Security/Medicare Wages or Taxes: Ensure the pastor’s wages are excluded from Social Security/Medicare wage and tax calculations on Form 941.
5. Exemption from Self-Employment Tax
•Form 4361: Pastors can apply for an exemption from self-employment tax by filing Form 4361. However:
•The form must be filed within the first two years of receiving ministerial income.
•This exemption must be based on a religious objection to public insurance programs (such as Social Security), not simply a desire to avoid paying taxes. The pastor must certify that this objection is consistent with their denominational teachings and personal beliefs.
Resources for Further Guidance
•IRS Publication 517: Social Security and Other Information for Members of the Clergy and Religious Workers
•IRS Form 4361 Instructions: Application for Exemption From Self-Employment Tax
•Church & Clergy Tax Guide by Richard Hammar
•IRS Minister Audit Techniques Guide: Minister Audit Guide
If you work with churches get it right!
Tag: personal-finance
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Mastering Farm Income Averaging to Optimize Tax Outcomes
Farm Income Averaging (FIA) is a specialized provision for agricultural taxpayers under IRC §1301 that enables them to spread “elected farm income” (EFI) over the current year and the prior three tax years. Properly applied, it allows farm taxpayers to minimize tax burdens during high-income years by utilizing the lower tax brackets from prior years. Here’s how it works in detail and how tax professionals can implement it effectively.
Mechanics of Schedule J
FIA is reported on Schedule J (Form 1040). The process works by evenly allocating the client’s EFI among the current year and the prior three tax years (base years). Schedule J splits the EFI into three equal parts and assigns those portions to the taxable income of the base years. The IRS then calculates the tax effect of this allocation to determine the client’s total tax liability for the current year.
This mechanism does not impact self-employment tax; it only adjusts the income tax calculation. Additionally, FIA can be applied even if the farm is owned through an entity like an S corporation or partnership, as long as at least 66.67% of the taxpayer’s gross income is derived from farming activities (IRC §1301(b)).
Starting Point: Analyze the Lookback Period
To effectively use FIA, tax professionals must identify the highest income year within the three prior base years and the shallowest tax bracket trough to begin planning. This ensures that the client’s EFI fills the unused portions of the lower brackets first:
1. Review Prior Years’ Returns: Examine the taxable income of the client’s prior three years and identify the amount of unused room in the 10%, 12%, and 22% brackets.
2. Determine EFI Allocation: Using Schedule J, allocate current-year EFI into the shallowest tax brackets of the base years, avoiding unnecessary overflow into higher brackets.
3. Maximize Bracket Utilization: Allocate just enough EFI to fully utilize the lowest brackets in each base year while minimizing spillover into higher brackets.Planning Opportunities for Major Taxable Events
1. Retirement Years: Farmers transitioning into retirement often have lower income levels, leaving their lower brackets largely unused. Income averaging allows them to offset high-income years (such as the final operating year) by leveraging the tax brackets in the retirement period and the three prior years.
2. Farm Sales and Depreciation Recapture: Sales of farm property or equipment often trigger substantial depreciation recapture, which is taxed as ordinary income under IRC §1245 or §1250. FIA can mitigate the recapture’s tax effect by allocating that income to prior years’ lower tax brackets, reducing the overall rate at which it is taxed.
3. Creating Troughs Proactively: Farmers can plan ahead to create larger “troughs” in the prior three years by strategically accelerating expenses or deductions. For example, they might prepay input costs, purchase necessary equipment, or utilize bonus depreciation. This lowers taxable income in those years, leaving more room in the lower brackets to maximize the benefits of FIA in future high-income years, such as when selling the farm or transitioning to retirement.Key Considerations for Effective FIA
•Three-Year Lookback: Income averaging doesn’t just split current-year income into the prior three years—it also lets taxpayers utilize the current year’s brackets. This can create opportunities to offset income spikes.
•Farms Held in Entities: For S corporations or partnerships that pass income to a Form 1040, the same rules apply if more than two-thirds of gross income comes from farming activities.
•No Impact on SE Tax: Farm income averaging only applies to the income tax calculation and doesn’t reduce the self-employment tax liability of the taxpayer.
•Coordination with Retirement and Other Strategies: Combining FIA with retirement distributions or installment sales can further enhance tax savings.Relevant Tax Code Sections
•IRC §1301: Governs the rules for income averaging for farmers and fishermen.
•IRC §1245 and §1250: Relate to depreciation recapture for tangible and real property, which often triggers ordinary income upon sale.
•IRC §469(h)(3): Defines materially participating farmers, which is important for determining eligibility under farming rules.Takeaway
Farm Income Averaging is a flexible, farmer-friendly tool that allows agricultural taxpayers to balance high-income years against prior lower-income periods. Tax professionals who master Schedule J and use the “shallowest trough” approach can maximize their clients’ tax savings. Additionally, helping clients proactively create troughs in low-income years through accelerated deductions or expenses can further enhance the effectiveness of FIA. By integrating FIA into comprehensive tax planning, including retirement and farm sale strategies, you can help clients retain more of their hard-earned income while staying compliant with IRS rules.
agtax #farmers #agribusiness
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Stepped-Up Basis at Death for Rental Real Estate: A Guide for Tax Professionals
When a spouse passes, jointly owned rental property typically qualifies for a stepped-up basis on the deceased spouse’s share under IRC §1014(a). This adjustment is crucial for ensuring accurate depreciation calculations and minimizing errors on future tax filings. Unfortunately, many tax professionals overlook this adjustment, particularly for depreciation, leading to potential errors that can affect clients’ financial outcomes. Here’s a breakdown of the process, the rules, and why proper calculations are essential.
Example Scenario: Jointly Owned Rental Property
•Married Couple: John and Mary jointly own a rental property with a basis of $300,000.
•Fair Market Value at Date of Death: $500,000.
•John passes, and Mary inherits John’s 50% interest in the property.Step 1: Determining the Stepped-Up Basis
Under IRC §1014(a)(1), the inherited 50% interest in the rental property receives a step-up in basis to its fair market value (FMV) at the date of John’s death. Mary’s new basis is calculated as:
•Mary’s original 50% ownership (no step-up): $150,000.
•John’s stepped-up basis for the inherited 50% interest: $250,000 (50% of FMV).Mary’s Total Basis After Adjustment: $400,000 ($150,000 + $250,000).
Step 2: Adjusting for Depreciation
The stepped-up basis must be depreciated separately from the original basis. Here’s how to calculate and apply depreciation:
1.Original Basis Depreciation: Mary continues to depreciate her original $150,000 (50% of $300,000) over the remaining useful life of the property.
2.Stepped-Up Basis Depreciation: The stepped-up basis of $250,000 must be depreciated as a new asset starting on the date of death over the appropriate class life, typically 27.5 years for residential rental property under IRC §168(c).Step 3: Depreciation Recapture Upon Sale
When Mary sells the property, depreciation recapture applies differently:
•Depreciation claimed on the stepped-up basis is not subject to recapture. This is because the stepped-up basis is treated as new property under IRC §1014(a).
•Depreciation claimed on the original basis remains subject to recapture under IRC §1250.Step 4: Correcting Errors in Depreciation
If depreciation adjustments for the stepped-up basis were not properly applied, you can correct them using a Section 481(a) adjustment. This adjustment allows taxpayers to account for prior missed depreciation deductions in the current year without amending prior returns, provided it meets the requirements under Rev. Proc. 2015-13.
Why Proper Basis Calculation Matters
Accurately applying the step-up and proper depreciation has several benefits:
1. Tax Minimization: Ensures that depreciation deductions are maximized for the client.
2. Avoiding Overstatement of Gain: Without proper adjustments, the gain on sale may be overstated, resulting in overpayment of tax.
3. No Recapture on Stepped-Up Basis: By correctly claiming depreciation on the stepped-up portion, clients avoid unnecessary recapture taxes on that portion.Notes for taxpayers in Community Property states
In community property states, the death of one spouse often results in significant tax benefits for the surviving spouse, particularly concerning the step-up in basis. Community property rules govern how property is owned and treated for tax purposes, and these rules differ from those in common law states.
Community Property States
The nine community property states are:
• Arizona
• California
• Idaho
• Louisiana
• Nevada
• New Mexico
• Texas
• Washington
• Wisconsin
Additionally, Alaska allows couples to opt into community property treatment by agreement.
Key Impact of a Spouse’s Death in Community Property States
1. Full Step-Up in Basis
Under IRC §1014(b)(6), in a community property state, when one spouse dies, the entire property (not just the deceased spouse’s half) receives a step-up (or step-down) in basis to the fair market value (FMV) at the date of death. This rule applies regardless of who inherits the deceased spouse’s share.
Example:
• John and Mary own rental property as community property with a total basis of $300,000.
• FMV at John’s death: $600,000.
• The entire property’s basis is stepped up to $600,000, and Mary can use this as the new starting point for depreciation and gain calculation.
This differs from common law states, where only the deceased spouse’s share typically receives the step-up.
Relevant Case Law and References
1. IRC §1014(a): Provides the rule for stepped-up basis at death.
2. IRC §168(c): Establishes the class life and depreciation rules for rental property.
3. IRC §1250: Governs depreciation recapture for real property.
4. IRS Publication 527: Offers guidance on depreciation and basis adjustments for rental property.
5. Case Law Example: Adams v. Commissioner, 85 T.C. 359 (1985) — Reinforces proper allocation of basis and depreciation adjustments.Conclusion
Tax professionals must ensure accurate stepped-up basis calculations and apply depreciation adjustments correctly when one spouse passes. These adjustments are critical for minimizing taxes on sale and avoiding depreciation recapture issues. If prior errors exist, leverage Section 481(a) adjustments to bring depreciation in line.
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