Rendering to Caesar What Is Caesar's
How Tax Laws Affect the Church
by Frank Sommerville
American churches enjoy freedom to worship God as they see fit. At the same time, churches are tax-exempt organizations, and this status limits some of the business operations of the church. Federal tax laws regulate the financial transactions of the church. Since tax exemption is a privilege rather than a right, tax exemption involves both federal and state requirements. This article does not contain all of the requirements to remain tax exempt. I do, however, highlight four areas where churches frequently violate tax laws.
Excess Benefit Transactions
Excess benefit transactions may cost a minister up to 325 percent times the excess benefit. Most ministers are not familiar with the term intermediate sanctions. Since 1995, the Internal Revenue Service may impose an excise tax (sanction) on ministers and other church leaders who receive excess benefits from a church. Most tax professionals refer to this excise tax as an intermediate sanction.
Excess benefit transaction includes many facets. It applies when someone in authority receives more money from the church than is appropriate under the circumstances. For example, an excess benefit transaction is any taxable fringe benefit the minister receives,1 but he and/or the church fail to report the benefit as taxable income.
Another type of excess benefit transaction arises when the minister receives an unreasonable amount of compensation. I list further explanations of these excess benefit transactions below.
In addition to the minister’s exposure to the 325 percent of the excess benefit, other church leaders who allow excess benefit transactions may pay a 10 percent penalty as well. This statute caps the sanction at $20,000 for church leaders who allowed the benefit but did not personally benefit from the transaction.
Failure to report taxable benefits
Under Section 61 of the IRS Code (Code), every financial benefit a minister receives from a church is taxable unless a specific Code section excludes that item from taxable income. Code Section 107, ministers housing allowance, is an example of a Code section that excludes a specific benefit from income tax. Like Section 107, all exclusions from taxable income include many terms and conditions before that exclusion applies.
Most churches do not employ human resource specialists; therefore, they are not always aware of those terms and conditions. Since fulfilling the terms and conditions rarely occurs without deliberate efforts, many churches fail to fulfill the terms and conditions needed for exclusion from taxable income. If the church has not performed a review of its fringe benefits, the fringe benefits are likely taxable and must be included in Box 1 of Form W-2.2 I strongly suggest that churches engage a tax professional to conduct a review of fringe benefits every 3 to 5 years.
Most churches love to honor their ministers by providing benefits to them that others do not receive. Frequently, thechurch omits these benefits from the minister’s taxable income because they do not go through payroll. For example, a church may receive a love offering that benefits its minister. The church must add this love offering to the minister’s taxable income.
Another fringe benefit frequently omitted from taxable income includes discounts or complementary goods and services given to the minister. Code Section 132 excludes from taxable income employee discounts up to the gross profit the church makes on the sale of goods. Nontaxable employee discounts include discounts up to 20 percent for services provided by the church. For example, many churches allow the children of ministers to attend summer camp free or for a discount that exceeds 20 percent of the camp price. Since no Code section excludes this benefit from taxable income, the church must add the value of the summer camp to taxable income. If the district provides the camp, the entire amount of the discount represents taxable income to the local minister. The same concept applies to retreats3 and other church events.
Another form of excess benefit transaction relates to business expenses. The Internal Revenue Regulations excludes from taxable income business expense reimbursements that comply with a written accountable expense reimbursement plan. An accountable expense reimbursement plan requires adequate documentation for each expense item within 60 days of incurring the expense. For travel and entertainment expenses, adequate documentation includes the name of the individuals involved in the travel or entertainment, date, place of travel or entertainment, and business purpose of the travel or entertainment. A receipt is required for hotel bills or if the amount of travel or entertainment expense exceeds $75. If the minister fails to document adequately any business expense, the business expense reimbursement must be included in taxable income.
Frequently, ministers receiving a church credit card fail to document adequately all transactions related to credit card use. In addition, if the minister does not timely reimburse the church for personal charges on the church credit card, the personal charges remain an excess benefit transaction. Usually, the minister must reimburse the personal charge as soon as practical after making the charge.
A business expense frequently abused by churches relates to cell phones. If the church provides a cell phone to a minister, the cost of the cell phone and related services represents taxable income to the minister unless the minister adequately documents the business use of the phone. This means the minister must list each phone call made or received on the phone, the name of the individual on the other end of the call, and the business purpose of the call. Since most ministers lack the time to timely provide such documentation, the entire cost of the cell phone and related services represents taxable income.
Many ministers receive compensation far below a reasonable amount. Some ministers, however, receive compensation far exceeding a reasonable amount. The IRS definescompensation as all benefits received by the minister, taxable and nontaxable. This includes salary, housing allowance, expense reimbursements, fringe benefits, gifts, and bonuses.
To determine the amount of a reasonable compensation for a minister, the church must first determine what similar churches pay their ministers.4 Smaller churches may simply call other similarly sized churches and ask for their minister’s compensation. Once the church has determined what other churches pay, they must assemble an independent board or committee to set the minister’s compensation. The minister and his family members cannot participate. Further, employees who work under the minister also cannot participate.
Once the church creates an appropriate compensation body, the individuals may consider additional factors beyond what other churches pay. The courts have used the following factors in determining the amount of reasonable compensation:
(1) the employee’s qualifications,
(2) the nature, extent, and scope of the employee’s work,
(3) the size and complexity of the employer’s business,
(4) a comparison of compensation paid with the employee’s compensation,
(5) the prevailing economic conditions,
(6) the prevailing rates of compensation for comparable positions in comparable employers, and
(7) the employer’s salary policy that applies to all employees.
After reviewing the above factors, the compensation body then sets the minister’s total compensation. Written minutes should reflect this action and should include any documents relied on by the body, such as salary surveys. The compensation body should also include in the minutes the reasons behind setting the compensation at the level chosen.
If the church follows the above procedure, then the IRS has the burden to prove that the minister’s compensation is unreasonable. If the church does not follow these procedures, then the church and/or minister must prove to the IRS that the compensation is reasonable. If the court finds that the minister’s compensation exceeds a reasonable amount, then the excess over reasonable compensation is an excess benefit transaction, with the applicable costs and sanctions.
As stated above, the church leaders involved in setting the minister’s compensation may also be liable for a sanction for 10 percent of the excessive amount.
Ministers must qualify to exclude a housing allowance from taxable income. Under Code Section 107, a minister who satisfies all conditions contained in Section 107 may exclude from taxable income the qualifying amount of housing allowance. While many ministers are familiar with the concept, they frequently forget the detailed terms and conditions associated with this benefit.
Only qualified ministers may receive housing allowance. The IRS reserves this benefit for ordained, licensed, or commissioned ministers of the gospel who received their credentials from a church. Generally, specialized ministerial licenses do not qualify for a housing allowance.
In addition, the minister must be performing the duties of a minister during his work time. The Internal Revenue Regulations generally define the duties of a minister. The duties of a minister employed by a church generally include leading a worship service, performing sacerdotal functions, and managing the church or some significant segment of the church. A different test applies when the minister works outside the church.
Few churches use the term sacerdotal to describe a minister’s duties. The term sacerdotal originally arose within the Roman Catholic faith to describe those duties performed by the priests. Today, most churches define sacerdotal to include those duties normally expected of a minister by that church. Certainly, sacerdotal duties include performing weddings and funerals. But it also includes prayer, Bible study, preaching, teaching, counseling, leading church services, visiting the sick and infirm, and spreading the gospel through various means and media.
Once the individual is duly qualified as a minister and is performing ministerial duties, then the mechanical parts of the housing allowance must be performed. First, out of the minister’s total compensation, the church is responsible for designating in writing an amount as a housing allowance. This amount can range up to 100 percent of the minister’s compensation. The board or compensation committee should annually pass a resolution setting a fixed dollar amount of each minister’s housing allowance. The board or compensation committee may adjust the housing allowance during the year, but the adjustment will only apply prospectively. If the church provides a parsonage for the minister, the church is responsible for setting the fair rental value of the parsonage as furnished, plus utilities, and providing that information to the minister.
Second, the minister must track all cash expenses related to owning, occupying, or maintaining his primary residence. The minister will need to retain receipts should the IRS question his housing allowance.
Finally, the minister must determine the fair rental value of his home as furnished, plus utilities. The minister should not use a real estate professional associated with the church where he is serving.
The minister may exclude from taxable income the lowest of the amount designated by the church, the amount spent by the minister owning, occupying, and/or maintaining his primary home, or the fair rental value of the home as furnished, plus utilities.
As a side note, the housing allowance is taxable for self-employment taxes unless the minister has elected out of Social Security.
Most ministers correctly assume their church engaged them to preach sermons as part of their job responsibilities. They are usually unaware that the United States Copyright Act vests ownership of intellectual property created within the scope of one’s job with the employer. Combining these two concepts results in the church owning the sermons the minister created and delivered.
Normally, these rules do not create problems because the pastor’s sermons have little or no value outside his church. Some ministers, however, believe their message has broader application than their church. They convert these sermons into books and this is where the problems begin.
If the church owns the sermons, then it owns the original material that went into the book. Further, it also means that the book contracts must be with the church. The church is entitled to the royalties earned by the sale of the books.
Contrary to the ownership created by the Copyright Act, most ministers contract directly with the publisher and intend to keep the royalties. In other words, the minister falsely represents to the publisher that he owns the material in the book.
Once the minister and/or church become aware of this problem, they try to solve it by transferring ownership of the sermons to the minister. If they contact a tax professional, they learn that this plan creates tax problems.
To remain tax exempt, all church assets, including sermons, must be used exclusively for exempt church purposes. Stated another way, a church may buy goods and hire employees that further its exempt purpose. It cannot, however, do anything that helps the minister make money on the side, such as becoming an author. The church, of course, may sell the sermons to the minister at fair market value. The biggest problem with the sales plan arises when the church attempts to establish fair market value. (See intermediate sanctions above.) If the church undervalues the sermons, then the transfer may cost the minister 325 percent of the undervaluation. The church could also transfer the sermons to the minister and add the fair market value to his compensation, assuming the minister’s total compensation remains reasonable. This option faces the same hurdle as selling them to the minister: establishing fair market value.
The best approach to avoid these issues is to adopt policies and agreements to prevent the church from owning the sermons in the first place. This option usually involves the minister agreeing to refrain from using any church assets in creating his sermons. He must create them on his days off from the church and not use church equipment, such as a laptop computer, in creating his sermons. This solution also incorporates a written employment agreement to remove the creation of sermons from the job description and, usually, requires the minister to give a license to use the sermons for the purpose of the church recording the sermons and making copies of the sermons for members.
Another solution sometime used by ministers who want more control over their sermons involves creating a nonprofit religious organization separate from the church. This nonprofit organization’s purpose is to spread the gospel using the minister’s teaching and preaching. This nonprofit religious organization must qualify as tax exempt as described in Code Section 501(c)(3). The church donates the sermons to the nonprofit organization. The nonprofit organization then enters into book contracts and other uses of the sermons. The minister has more control over this organization than the church because fewer individuals are involved in the governance than in a typical church. Also, this organization can be used at all the churches employing the minister in his career. The disadvantage of this arrangement involves cost. It typically costs several thousand dollars to create this organization and secure IRS recognition of its tax exemption. Further, the annual costs to maintain this organization usually run several thousand dollars.
The rules discussed above apply equally to pulpit ministers, music ministers, and teaching ministers.
Unrelated Business Income
Churches must pay unrelated business income taxes when they engage in certain activities. Since 1954, the Code has imposed an income tax on tax-exempt organizations that engage in certain activities. These rules apply to churches, but churches routinely ignore them, sometimes out of ignorance and sometimes out of the misplaced notion that the IRS will never catch them.
Unrelated business income is an extremely complex topic. A church should not assume that the general rules discussed below are absolute. A single fact can turn UBI into tax-exempt income. If a church receives $1,000 or more of UBI, it must file Form 990-T with the IRS. Once a church believes it is required to file Form 990-T, it should engage a nonprofit tax professional to evaluate all sources of income to determine the proper amount of UBI for the church.
Two concepts are fundamental to understanding UBI. First, income from passive sources, such as interest, does not qualify as UBI. A church may generally earn interest or dividends without triggering UBI. Second, the way the income is spent by the church has no bearing on whether or not the income creates UBI. Many church fundraisers create UBI even though the church applies all funds to legitimate church purposes. For example, the church sells cookie dough to raise money for missions. The application of the funds to missions, an exempt purpose, does not affect the analysis for UBI purposes.
Generally, a church creates UBI based on the analysis of these three elements: (1) the church receives income from a trade or business; (2) the trade or business is regularly conducted; and (3) the trade or business is not substantially related to the church’s exempt purposes.
This analysis starts by looking at whether others conduct similar activities for a business. For example, if the youth conduct a car wash to raise money for the youth department, then the income from the car wash represents a trade or business because others operate car washes for profit-making purposes.
The second element looks at how regularly the church conducts the activity. For example, the church decides to conduct a garage sale one time. Though the activity may create UBI if regularly conducted, since it occurred once, the garage sale will not create UBI. For seasonal businesses (think the sale of Christmas trees), operating during the appropriate season will be deemed regularly conducted.
Finally, the activity cannot be substantially related to an exempt purpose. For example, the sale of Bibles will not create UBI because the sale of Bibles promotes the gospel, an exempt purpose. In contrast, the sale of the latest Dr. Phil book likely creates UBI.
In addition to the three elements discussed above, the Code contains three exceptions to the above rules. First, the sale of merchandise for the convenience of members and employees will not create UBI. As a result, the sale of soft drinks in the youth center will not normally create UBI. Second, the sale of donated merchandise will not create UBI. If the church operated a used clothing store that sold only donated clothes, then the store’s operation will not create UBI. Third, if the activity is operated by substantially all-volunteer labor, the activity will not create UBI. If volunteers provide substantially all the labor for the youth car wash, then the youth car wash will not create UBI.
Frequently churches operate bookstores. Bookstore operations, under normal circumstances, do not create UBI. In examining a church bookstore, the IRS determines UBI by an item-by-item analysis of the items sold. If all the items sold relate to exempt purposes, such as promoting the gospel, then the sale of those items does not create UBI. If the bookstore sells gift items or breath mints that are not related to an exempt purpose, then the sale of these items creates UBI unless one of the exceptions to UBI applies. If the bookstore is operated solely around service times, the bookstore operation will not generate UBI because it is operated solely for the convenience of its members. Also, if volunteers operate the bookstore, the substantially all-volunteer exception will apply and sales from the bookstore will not generate UBI.
A related category of activity can create UBI, though the activity is passive. It is called debt-financed income. In this category, rents generated from real estate assets purchased with debt are UBI. Rents generated from the rental of personal property, such as tables and chairs, create UBI.
Closely associated with UBI is sales tax. In many states, the sale of merchandise creates a taxable event requiring the church to collect sales tax on the transaction, even though the church is exempt from paying sales taxes on its purchases. In most states, churches are required to collect sales tax from their bookstore sales. The church should check with its local sales tax office to determine its responsibilities regarding sales taxes.
During the last 30 years, the Internal Revenue Code has grown to over 5.5 million words. This increase in the number of words creates complexity, including complexity for churches. As a result, churches struggle to comply with tax laws. Many churches believe since the IRS has never audited them, they do not need to change anything. They frequently seek tax advice from other churches and members instead of tax professionals intimately familiar with church tax laws. In many cases, this informal advice received from other churches and members is wrong, even if they consulted a very large church.
Together with other factors, many churches have created a substantial financial risk that threatens their existence. Even small churches could owe the IRS hundreds of thousands of dollars. Bivocational pastors also could easily owe the IRS tens of thousands of dollars.
While we have covered a few issues in this article, other substantial tax issues exist. In my 30 years of practice, I have yet to find a church that fully complies with tax laws. Those that get close to full compliance do so only after extensive efforts to do so. Since the liability is real and churches have shut down because of unpaid tax liabilities, the church cannot continue to ignore tax issues.
What is the church to do? First, the church must make tax compliance a priority. The church must attempt to comply with tax laws, like any other organization. If tax compliance is a priority, the church will train its staff regarding tax issues. The church will purchase church tax guides written by Richard Hammar to guide its staff.
Second, the church should engage tax professionals who are intimately familiar with the tax laws as they apply to churches. While virtually any tax professional is capable of learning the tax laws applicable to churches, most do not have the occasion, experience, or interest to study this area. The church should ask its tax professional what percentage of his professional time is spent working with churches and religious organizations. Finally, larger churches should require a tax compliance review conducted by a church tax professional every 3 to 5 years. This compliance review will provide the church with the knowledge it needs to comply with tax laws and is just as important as a financial statement audit in preserving the church assets.
1. For intermediate sanctions, the term minister includes relatives.
2. The church must report all taxable income in Box 1 of Form W-2. If the church omits taxable income from Box 1, the minister must still report the taxable income on his tax return. All future references to taxable income assume the church is reporting it in Box 1.
3. If the minister is required to render substantial services on behalf of the church at a church event, then the cost of attendance is not taxable to the minister. See Code Section 132.
4. See Richard R. Hammar and James Cobble, Jr., The 2009 Compensation Handbook for Church Staff, Chicago: Christianity Today International, 2008). To order, visit: http://store.churchlawtodaystore.com/20cohaforchs.html.