By Karen Kirchman
Publicity regarding churches and ministries has fueled many questions about ministry expenses and the use of ministry assets for personal benefit that could be grounds for excise taxes resulting from excess benefit transactions. These excise taxes are reported and paid by the individual who received the excess benefits, not the church or ministry. However, in abusive cases the Internal Revenue Code allows for the exempt organization’s status to be revoked.
Effective March 28, 2008, the IRS issued final regulations to clarify the requirements to retain tax exemption under 501(c)(3) and how this relates to excise taxes imposed under Internal Revenue Code Section 4958. Tax-exempt 501(c)(3) organizations cannot be organized or operated for the benefit of a private interest, such as designated individuals or their families or the organization’s creators. Code Section 4958 imposes excise taxes when excess economic benefits are provided to disqualified persons in a public charity. The final regulations illustrate the requirement that the exempt organization serve a public interest, prohibiting private benefit through excess benefit transactions.
The IRS position is that an excess benefit exists if a disqualified person receives a non-taxed taxable benefit from an exempt organization. For example, a pastor’s personal use of church property such as a cell phone, vehicle or credit card and certain non-accountable reimbursements were considered by the IRS to be excess benefits because the benefits were not included in the Form W-2 or on the pastor’s personal income tax return. The excess benefit existed because the benefit had not been identified as a taxable benefit.
Fair market value
If the fair market value of the personal use of the church property has been included as taxable income, it would not be an excess benefit item. If expense reimbursements have been provided under a written plan that requires proper substantiation by receipts documenting who, what, when and how it relates to the ministry, those amounts would not be an excess benefit.
An excess benefit can also exist if there is unreasonable compensation paid to any individual, considering both salary and all economic and non-economic benefits received. One of the conditions that must be met to qualify for 501(c)(3) exemption relates to “inurement.” The organization’s assets cannot provide a private benefit to an individual other than as reasonable compensation for services rendered to the exempt organization. Tax-exempt organizations that pay unreasonable compensation are violating one of the requirements for exemption and consequently may place the exempt status of the organization in jeopardy. At a minimum excise taxes are imposed to the disqualified person on the amount determined to be in excess of a reasonable compensation.
Excise taxes apply to disqualified persons, and in some cases to managers. A disqualified person is any person who at any time during the five-year period ending on the date of an excess benefit transaction, was in a position to exercise substantial influence over the affairs of the tax-exempt organization, or any family member of such a person.
Positions with substantial influence
The income tax regulations specify the following positions have the ability to exercise substantial influence:
- Voting members of the governing body
- President, chief executive officer or chief operating officer, including any person who regardless of title, has ultimate responsibility for implementing the decisions of the governing body or for supervising the management, administration, or operation of the organization
- Treasurer or chief financial officer, including any person who regardless of title, has ultimate responsibility or shared responsibility for managing the finances of the organization
- Persons with substantial influence in the organization, based on facts and circumstances, such as the founder or substantial contributors
In most church organizations, the senior pastor would be considered a disqualified person. If the pastor exercises substantial influence through authority to implement the decisions of the governing board, serve as a member of executive management, or supervise the operations of the organization, he is a disqualified person.
When is a manager subject to excise taxes? Any organization manager, officer, director or trustee who participates in an excess benefit transaction knowing it is such a transaction is subject to excise taxes. If the individual participates in an excess benefit transaction but their participation “is not willful and is due to reasonable cause,” they will not be subject to the excise tax. A manager who knowingly uses ministry funds to provide excess benefits to a disqualified person may be assessed excise taxes.
If excess benefits have been paid to a disqualified person, then a 25 percent excise tax can be imposed. Also, the excess benefits plus interest must be returned to the exempt organization from the disqualified person. If the excess benefit transaction is not repaid the taxes assessed can be 200 percent of the excess benefits.
If the IRS assesses the 25 percent tax against a disqualified person, it is permitted to impose an additional 10 percent tax on any organization manager who knowingly participated in the excess benefit transaction. This tax is limited to a maximum of $20,000 total tax on all managers per transaction. There is no limit to the tax for the disqualified persons receiving the excess benefit.
Comply with the code
If excess benefits have been paid to a disqualified person the individual can correct the excess by complying with Internal Revenue Code Section 4958, which specifies “undoing the excess benefit to the extent possible, and taking any additional measures necessary to place the organization in a financial position not worse than that in which it would be if the disqualified person were dealing under the highest fiduciary standards.”
The correction amount equals the sum of the excess benefit plus interest. The amount of interest is calculated from the date the excess benefit transaction occurred to the date of the correction. The interest rate used in the calculation must be equal to or greater than the applicable federal rate for the month in which the excess benefit transaction occurred. A disqualified person corrects an excess benefit by making a payment in cash or cash equivalents to the tax-exempt organization. Correction cannot be made by issuing a promissory note.
The correction must occur within the taxable period. According to Section 4958, the taxable period begins with the date on which the excess benefit transaction occurs and ends on the earlier of the date of mailing of the deficiency notice with respect to the initial 25 percent tax, or the date of the assessment of the initial 25 percent tax.
Exempt status revoked?
The final IRS regulations make it clear that “the determination of an organization’s tax-exempt status and the determination of the existence of an excess benefit transaction are separate determinations, involving distinct parties, different legal elements and separate processes, even though they may relate to the same facts.” In determining whether to continue to recognize the tax-exempt status of an organization that engages in an excess benefit transaction, all relevant facts and circumstances will be considered, including the size and scope of ongoing exempt purpose activities before and after the excess benefit transaction(s).
Other considerations are the size and scope of the excess benefit transactions collectively, in relation to the organization’s ongoing tax-exempt purpose activities and whether the organization has been involved in multiple excess benefit transactions with one or more persons. Also taken into account is whether the organization has implemented safeguards that are reasonably calculated to prevent excess benefit transactions and whether the excess benefit transaction has been corrected or the organization has made good faith efforts to seek correction from the disqualified person(s) who benefited.
What does your organization need to do? Correction of any excess benefit should occur as quickly as possible after the benefit is discovered. Correction only after the IRS discovers the excess benefit transaction(s) is never, by itself, a sufficient basis for continuing to recognize exemption. The organization has a responsibility to find and correct any excess benefits before they are examined.
Identify corrective actions
Safeguards implemented to prevent excess benefit transactions will be considered in determining the continuation of exempt status. Once an excess benefit transaction has been identified, the organization’s corrective actions, or reasons the transaction is not corrected, will also be considered in looking at continuing exemption.
A regulatory assessment may help an organization and those charged with governance to determine if it is operating under the highest fiduciary standards in an effort to avoid any excess benefit transactions. This assessment can be used to identify the disqualified persons and transactions that could be considered excess benefits or excessive compensation.
Policies and procedures, internal controls, compensation packages and written benefit plans are reviewed in a regulatory assessment. Recommendations are provided to identify and help correct abuses and excesses and establish additional safeguards as needed. An accounting firm with expertise in this area may be needed to get you on the right track for the future.
Circular 230 Disclosure: To ensure compliance with requirements imposed by the IRS, we inform you that the U.S. federal tax advice contained in this communication, including any attachments, is not intended or written to be used and cannot be used, for the purpose of (i) avoiding penalties under the Internal Revenue Code or (ii) promoting, marketing or recommending to another party any transaction or matter addressed herein.
Karen Kirchman is a CPA and a shareholder at Stanfield & O’Dell, P.C., Tulsa, OK, a public accounting and consulting firm that specializes in tax, consulting and audit services for Christian ministries. [stanfieldodell.com]
Security Group Borne from church incident
The National Association of Church and School Security (NAOCSS) was founded in December 2007 after the shooting at New Life Church in Colorado Springs, CO. The two founders, John Casey and Tim Priebe, were on New Life’s security team at the time of the shooting. Casey had for three years previous to the shooting been the volunteer head of security at New Life and was instrumental in developing the team and policies that were in place that day.
After the shooting, New Life was inundated with questions and requests from churches across the nation. Seeing a need, Casey and Priebe started the association to assist churches with training as well provide information. Combining both founders’ past law enforcement experience, Casey’s extensive military security experience and Priebe’s 14 years of legal practice, the association is uniquely posed to handle the issue of security and the church.
Churches can become members through the association’s Web site, naocss.com. The association provides training and information to assist all types and sizes of churches. The training covers how to start a security team through how to maintain and train experienced and established teams. Members can sign up for instant electronic notification of events or threats that could be taking place in their city or state. Members can also communicate with one another to inform and discuss local issues that affect them.
NAOCSS has teamed up with Paragon Training Group Inc. to assist those members that want hands on training in their area or church. NAOCSS and Paragon will be presenting the first annual security conference at Heritage Christian Center in Denver, CO on Nov. 6-8. Further information can be obtained from Tim Priebe through the Web site, naocss.org, at (719) 573-5531 or (888) 573-5531, or by e-mailing Tim.Priebe@naocss.org.