By Elaine L. Sommerville
The issues surrounding compensation for key employees have grown more complex.
Errors in compensation planning can be costly to both churches and to the employees.
Churches and all organizations exempt under the Internal Revenue Code Section 501(c)(3) are prohibited from allowing the assets or profits of the organization to inure to the benefit of an insider or a control party. If a key employee is paid unreasonable compensation or uses other assets for personal benefit without fair consideration, a church’s exempt status may be threatened.
IRC Section 4958 provides for monetary penalties (intermediate sanctions) to be assessed to people who receive unreasonable compensation or improperly use the assets of the organization (excess benefit transactions). Penalties may reach 225 percent of the value of the unreasonable compensation or the assets misused.
Additionally, assets improperly used or diverted must be returned to the organization. In cases of extreme abuse where the improper reporting of compensation or use of church assets results in a significant understatement of an employee’s income, the employee may face charges of criminal tax evasion.
IRC Section 4958 provides guidance on the actions to be taken to avoid the above defined risks. Internal Revenue Reg. 53.4958-6 provides a rebuttable presumption for reasonable compensation. Compensation must be determined by people independent to the recipient, be based on outside comparable data and be documented in writing.
Error No. 1: The single most costly error arises from a lack of understanding of tax law. The basis of U.S. tax law is that everything that benefits an employee is a form of compensation for services. Additionally, all benefits are taxable until IRC provides an exclusion from tax.
Many churches tend to consider only cash benefits as compensation and not include noncash benefits or items that are paid directly by the church. Common elements of compensation improperly handled include retirement benefits, autos, clothing allowances, payment of personal expenses via the church credit cards, free tuition at the church-sponsored school, life insurance, spousal and family travel, and the use of church assets to create privately owned intellectual property.
Failure to consider these additional elements of compensation creates the following adverse consequences:
- The compensation package is not properly documented in writing;
- The taxable income of the key employee can be understated; and
- The actual total compensation package may exceed reasonable compensation.
Error No. 2: Decision makers must be independent to the employee being compensated. However, many times decision makers may either be relatives of the employee or may work under the employee. This error may appear even where there is an appearance of independence.
For example, a church places its attorney on the compensation committee handling the approval of the senior pastor’s compensation. If the senior pastor has the ability to hire or fire the outside legal counsel for the church, then the attorney is not independent to the pastor.
Error No. 3: Obtaining reliable outside comparable data is challenging. Common errors arise in (a) the source of the data, (b) the age of the data and (c) the interpretation of the data.
Source of the data – The Internal Revenue Regulations under IRC Section 4958 require outside comparable data be used in determining reasonable compensation, but there is little guidance given as to what outside data may be used. There are several reliable salary surveys available to churches, but larger churches do not generally find these surveys helpful and may use outside compensation consultants. The IRS has not defined the criteria for who is to be considered a qualified compensation consultant.
However, it has stated that attorneys and CPAs that do not work as compensation experts on a full-time basis and have not been specifically trained in the area of compensation analysis are not qualified consultants for this requirement. This includes attorneys and CPAs who work extensively with churches.
A consultant should have strong credentials and experience in the field of compensation and human resources. An unqualified consultant can negate the validity of the outside data and place both the church and the employee at great risk.
Age of the data – There is a misconception that once data is obtained, it never needs to be updated. There is no clear definition of how long a church may rely on outside date, but the IRS has stated that data five years old was too old to be relied on for purposes of meeting the requirements for IRS Section 4958. Salary data should be updated every few years as well as when there is a change in the facts and circumstances on which the data is based. Example: The size of the church has significantly changed.
Interpretation of the data – Any data obtained has to be interpreted within the context of the church’s operations. The decision makers must understand the data provided and view it in the proper context of other pertinent data, that is, the employee/minister’s qualifications; the nature and scope of the employment; the size and complexity of the church; the prevailing economic conditions of the area; the church’s overall salary philosophy; and the financial condition of the church. These areas need to be considered in order to make the data more relevant
With issues involving compensation, churches should seek advice from professionals trained in the unique rules that surround churches. While this may be an increased cost to the church, preventative costs are always less than the costs incurred when the IRS or a state’s attorney general comes calling.
Elaine L. Sommerville is a partner in the law firm Sommerville & Associates, PC, in Arlington, TX. www.nonprofit-tax.com