By David Middlebrook and Robert W. Rucker
In this modern era, many churches are offering more and more services to its congregants to attract new members, retain established members and create revenue to operate the church or fund its programs. Common examples may include a bookstore or coffee bar. As a general rule, a church is not taxed on its income or revenues from an activity that is substantially related to the religious or charitable purposes of the organization.
For example, a church’s income received from tithes and offerings is not taxable because the receipt of tithes and offerings is related to the church’s exempt religious purpose. People contribute money to the church as part of a religious conviction, to help the church offer religious services, and not because they expect anything of equal financial value in exchange. However, if a church regularly carries on business that is not substantially related to its exempt purpose then the organization is subject to tax on the unrelated business.
If a church owns a commercial restaurant, any income that the restaurant generates will be taxed because it is not related to the church’s primary exempt purposes. The income from the restaurant is considered by the IRS to be unrelated business income tax or UBIT as it is commonly referred to by professionals in the industry.
This is the case even if the church were to use the profits of the restaurant for exempt purposes (i.e. it used the profits for church expenses or to fund a church mission trip). By the way, the restaurant example is based upon an actual case.
Three-part test of involvement
Whether or not a church is involved in an activity that could result in it owing UBIT is based upon a three-part test (all three have to be present):
1. Is the activity generally considered a trade or business? This usually means that the activity involves providing the sale of goods and services in exchange for payment. Potentially, a church bake sale could be characterized as a trade or business because it involves providing goods (cookies) in exchange for money, although for the reasons set out below, it is usually not going to be treated as generating UBIT.
2. Is the activity regularly carried on? Most church bake sales occur on certain designated weekends, and accordingly are not viewed as being regularly carried on. However, if the church sells baked goods every weekend, or even every day, this could satisfy the requirement.
3. Is the activity substantially related to an exempt purpose? If the activity does not contribute in an important way to the exempt purposes of the church, it could lead to tax liability. Many churches offer services that have an appearance of commerciality but are not treated that way because their underlying purpose is to help the church be effective in spreading religious understanding or promoting fellowship.
Bookstores and coffee bars run by the church are considered to be for the convenience of the church members and visitors. This makes it more likely that they will come to church and not leave to get coffee, have access to books that the church believes are relevant to religious study and similar matters of convenience.
On the other hand, if a church has a billboard on the highway advertising its bookstore or coffee bar, it begins to have a greater commercial appearance and will more likely be viewed as a commercial trade or business.
Raising red flags
Depending on how much UBIT is generated will depend on how the IRS is likely to respond. A church can generate an “insubstantial” amount of UBIT and not jeopardize its tax-exempt recognition (it would still need to pay tax on the unrelated business activity). If a church generates a “substantial” amount of UBIT, it will raise red flags to the IRS and potentially jeopardize the church’s tax-exempt recognition.
Unfortunately, there is usually no way to quantify what amounts to substantial unrelated business or to determine how much unrelated business an exempt organization can engage in. In certain circumstances the IRS will consider formulas such as an 85 percent rule regarding use of square footage at a church for religious purposes, meaning if the church uses less than 85 percent of its space for commercial activity, then this is considered not substantial. Rather, the IRS considers all of the facts and circumstances of the particular case.
If a substantial portion of the church’s income is from sources unrelated to its exempt purposes, then it’s likely risking its tax-exempt status by virtue of engaging in the unrelated business or is risking facing a tax bill. That being the case, the general rule of thumb regarding UBIT should be: Substantial revenue + unrelated activity = Jeopardizing of tax-exempt recognition.
If the church has UBIT of $1,000 or more annually then the church is required (as of this writing), to file Form 990T with the IRS (generally, unlike other nonprofit organizations, a church is exempt from filing an annual Form 990). Many churches do want to have to file this form because it is a publicly available document and requires the church to disclose the salaries of its top employees and other financial information that they normally wish to remain confidential.
Growing sentiment for disclosure
Each church will have to balance their need for revenues compared with the desire for privacy in church financial matters. Incidentally, there appears to be some growing sentiment that churches should no longer be given special protection or status under the First Amendment and should have to disclose all financial activities just like any other charity.
Certain kinds of income or revenue are also usually considered exempt from unrelated business taxes. These include rental income, capital gains such as from the sale of a property, dividends, royalties and interest income. However, for each of these categories there will be factual differences and certain other rules that can affect whether or not a tax may be due.
The church should not just assume that because its income is derived from one of these sources that it is tax-exempt, but should have its tax, financial and legal professionals help make that determination.
David Middlebrook is a partner and Robert W. Rucker is an attorney with Anthony and Middlebrook P.C., The Church Law Group, Grapevine, TX. [www.churchlawgroup.com]