What is a “church,” and how is it taxed?
|EXECUTIVE SUMMARY |
| If the IRS classifies an organization as a church it may enjoy several tax-related benefits, such as an exemption from federal income tax, exemption from applying for tax-exempt status, exemption from unemployment taxes and exemption from filing certain annual information returns.
The term church is not specifically defined in the Internal Revenue Code but is used in a generic sense that includes all places of worship including synagogues and mosques. The IRS listed 14 criteria that are important in deciding whether an organization is a church. An organization is not required to meet all of the 14 criteria to be classified as a church, but the IRS does not say which ones or how many are required for the desired classification.
The “corporation sole” is a legitimate corporate form that allows a bona fide religious leader to hold property and conduct business for the benefit of a religious organization. However, the nebulous definition of a church has led to abuses which earned the corporation sole a place on the 2005 IRS Dirty Dozen tax scam list.
If a church meets the five criteria listed in section 501(c)(3) of the Internal Revenue Code, it is automatically considered tax-exempt. Even so, if a church has unrelated business income, that income is subject to income tax.
Churches must still withhold payroll taxes from the wages of their employees even though the church is generally exempt from paying income tax. In addition, there are special rules regarding the payment of Social Security and Medicare taxes for clergy.
Frances E. McNair, CPA, PhD, is a professor of accounting at Mississippi State University in Starkville. Her e-mail address is email@example.com . Charles R. Pryor is a PhD student at Mississippi State University. His e-mail address is firstname.lastname@example.org .
merica’s tradition of religious freedom is as old as the country itself—and results in an incredible diversity of form and structure among its religions. Organizations that the IRS classifies as “churches” may enjoy several tax-related benefits: They can be exempt from federal income and unemployment taxes, from applying for tax-exempt status and from filing certain annual tax nformation returns. This article examines the critical definition of a church for tax purposes, the requirements for tax-exempt status and some of the most common areas of misreporting by houses of worship.
Note that the Internal Revenue Code uses the term church in a generic sense that includes synagogues, mosques and all places of worship. Hence, we will use the IRS term church in a generic sense in this article.
The term church is found, but not specifically defined, in the Internal Revenue Code. The term is not used by all faiths; however, in an attempt to make this article easy to read, we use it in its generic sense as a place of worship including, for example, mosques and synagogues.
IRC section 501(c) describes several organizations that qualify for tax-exempt status, including churches, but does not provide a precise definition of a “church.” However, IRS Publication 1828, Tax Guide for Churches and Religious Organizations, l ists 14 criteria the IRS considers important in deciding whether an organization qualifies. They are
A distinct legal existence.
A recognized creed and form of worship.
A definite and distinct ecclesiastical government.
A formal code of doctrine and discipline.
A distinct religious history.
A membership not associated with any other church or denomination.
An organization of ordained ministers.
Ordained ministers selected after completing prescribed studies.
A literature of its own.
Established places of worship.
Regular worship services.
Schools for the religious instruction of the young.
Schools for the preparation of ministers.
|There are more than 300,000 congregations in the United States, including Protestants, Roman Catholics, Mormons, Jews, Muslims and others.
Source: www.fact.hartsem.edu .
An organization is not required to meet all 14 criteria in order to be classified as a church, but the IRS has been unwilling to say how many should be met or whether some are more important than others. Usually, a combination of these characteristics along with facts and circumstances is used to determine whether an organization is a “church” for federal tax purposes. If an organization is unjustly denied church classification, its only recourse is in the courts.
In one case a District Court’s determination that a family was not a church appeared to be relying on the 10th, 11th and 12th criteria. The court ruled that an organization was not a church if it was not reasonably available to the public. In other recent cases, the courts used some of the 14 criteria but the court also showed that some or even most of the criteria may not apply to a specific situation.
So how can an organization be sure it meets the IRS definition of a “church”? Even though not required to do so, it may want to apply for an official ruling of tax-exempt status to ensure all available benefits accrue to the organization and its beneficiaries—for instance, that income related to its exempt purpose is, in fact, tax-exempt and contributions are generally tax-deductible. However, the application for tax-exempt status (form 1023) is not without costs. A user fee of $500 is required if revenues are expected to exceed $10,000 annually. Fees change periodically; see form 8718 for current fee information.
In some cases the nebulous IRC definition of a church has led to shameless tax scams. The proliferation of one such scam—the corporation sole—has earned it a place on the IRS 2005 Dirty Dozen tax scam list. Promoters of this scam often argue that since neither the tax code nor the courts have explicitly defined a church, the taxpayer is free to do it, which affords the taxpayer the benefits of 501(c)(3) status.
A corporation sole is a legitimate corporate form, available in 16 states, which may be used by bona fide religious leaders to hold property and conduct business for the benefit of a religious organization. The purpose is to ensure the continuity of ownership of property dedicated to the use of a legitimate religious organization. Revenue ruling 2004-27 makes it clear that a taxpayer may not use a corporation sole to hide income or assets or to evade income taxes. In fact, establishing a corporation sole based on anything other than a bona fide religious organization can result in substantial penalties.
Some taxpayers have tried to claim their family was a church of which they were the head, and their personal income or assets belong to the corporation sole, which is tax-exempt. Not only have the courts consistently found such arguments to be frivolous, they also have “imposed penalties for making such arguments, and upheld criminal tax evasion convictions against those making or promoting the use of such arrangements.” Tax preparers also may be found culpable in such a tax scam. Potential penalties include a per-return fine of up to $1,000, a lump-sum penalty of up to $100,000 and up to three years’ imprisonment. There also is evidence the IRS intends to pursue perpetrators of this scam: In March 2004 the IRS issued a press release warning taxpayers to be wary of the corporate sole scam, and in subsequent weeks the Department of Justice filed suit against alleged promoters of the scam in eight states, demanding among other things that they surrender their client lists.
In order for an organization to qualify for tax-exempt status, it must meet five general requirements outlined in IRC section 501(c)(3). These are
It must be a corporation. IRC section 501(c)(3) says that a tax-exempt organization must be a corporation but IRC regulations do not require an “official” corporation. According to Treasury regulations section 1.501(c)(3)-1(b)(2), a church must describe its activities in articles of organization, such as a corporate charter, a trust instrument, articles of associations or any written instrument by which an organization is created.
It must be organized and operated exclusively for religious, educational, scientific or other charitable purposes. A “church” must set forth its tax-exempt purpose in its articles of organization (or other similar document referred to above). The exempt purpose may be more specific than those listed in section 501(c)(3), but it cannot be broader than those listed. The organization’s assets must be distributed to another exempt organization or used for an exempt purpose upon dissolution. Specific wording that meets the organizational test can be found in IRS Publication 557.
The organization also must be operated primarily for the tax-exempt purpose. It may engage in income-producing activities unrelated to the tax-exempt purpose as long as these activities are not a substantial part of the organization’s activities, but these activities are subject to federal tax. The unrelated business income tax (UBIT) is discussed in a later section of this article (page 74).
Net earnings may not inure to the benefit of any private individual or shareholder. This simply means that a tax-exempt organization can make payments to insiders (employees or clergy) or to other private parties (founders, trustees or contributors) only if they are for reasonable compensation for service, for the fair market value of real or personal property or to further the tax-exempt purpose. Prohibited transactions include payment of dividends, unreasonable compensation and transferring property for less than fair value.
No substantial part of the organization’s activity may be attempting to influence legislation. IRC section 501(h) prohibits tax-exempt organizations from engaging in “substantial” efforts to influence legislation. But what are substantial efforts? In Seasongood v. Commissioner , 227 F2nd 907 (6th Cir. 1955), the court set 5% of time and effort as a benchmark, but in other cases the courts have used a percentage of the budget. In the Haswell case, 500 F2nd 1133, the court found that using 16% to 17% of the budget was substantial. The IRS has not set a specific percentage of time, effort or budget, but says it will consider a number of factors, including time and expenditures. According to Publication 1828, a church will be regarded as “attempting to influence legislation if it contacts or urges the public to contact members or employees of a legislative body for the purpose of proposing, supporting or opposing legislation or if the organization advocates the adoption or rejection of the legislation.” However, the IRS list of activities that should not jeopardize tax-exempt status in Publication 1828 includes conducting educational meetings, preparing and distributing educational materials and considering public policy issues in an educational manner. Organizations exempt as a church, auxiliary, etc., may not make the 501(h) election.
The organization may not intervene in political campaigns. Participation in political activities even to an insubstantial degree can cause a church to lose its tax-exempt status. Contributions to political campaigns or public statements of position made by the organization are clearly in violation.
Publication 1828 cites certain activities that may not be prohibited, including voter education activities conducted in a nonpartisan manner, voter registration activities and get-out-the-vote drives. Still, voter education activities that favor or oppose a candidate or a group of candidates over the others are prohibited.
Individuals, including clergy, are allowed to speak for themselves—even on important public policy issues. But religious leaders cannot make partisan comments in official publications or at official functions. A religious body may invite a candidate to speak at its events as long as it provides equal opportunity to all candidates seeking the same office. Here are two examples from Publication 1828.
Example 1: Minister A is well known in the community. Candidate T publishes a full-page ad in the local newspaper listing five prominent ministers who have personally endorsed her, including Minister A, who is identified in the ad as the minister of Church B. The ad says, “Titles and affiliations of each individual are provided for identification purposes only.” The ad was not paid for by the church and the ad is not in an official publication of the church. Since the endorsement was made by Minister A in a personal capacity, the ad does not constitute campaign intervention by the church.
Example 2: During regular services of Temple M, Rabbi D’s sermon mentioned the importance of voting in the upcoming election, and Rabbi D said, “It is important that you all do your duty in the election and vote for Candidate W.” Since Rabbi D’s remarks indicating support for Candidate W were made during an official service, they constituted political campaign intervention attributable to Temple M.
Tax-exempt status also may be obtained through a tax-exempt parent organization, provided the parent provides the IRS with a list of affiliated churches and religious organizations. An important caveat is that “religious organizations” other than “churches” whose annual gross receipts normally exceed $5,000 generally must apply to the IRS for recognition of their tax-exempt status. It is important to distinguish between churches and other religious organizations because the former are afforded special tax rules, especially concerning employment taxes for their clergy. Religious organizations that are not churches include nondenominational ministries, interdenominational and ecumenical organizations and other entities whose principal purpose is the study or advancement of religion.
If a church fails to meet any one of the criteria required for tax-exempt status by the IRS, it can lose its tax-exempt status and the organization and its leaders may incur significant penalties in the form of excise taxes. It is also vitally important to understand the limitations of tax-exempt status even if recognized by the IRS. Only certain income is exempt from federal income tax; an organization still may have significant reporting and taxation obligations, as we shall soon see.
In 2003, Congressman Jones (R-N.C.) introduced the “Houses of Worship Free Speech Restoration Act,” whose purpose is to amend the Internal Revenue Code to protect the religious free exercise and free speech rights of houses of worship. If it passes, houses of worship would not lose their tax-exempt status because of the content, preparation or presentation of any homily, sermon, teaching, dialectic or other presentation made during religious services or gatherings. Although the bill did not pass in 2003 or 2004, it has been reintroduced in Congress as HR 235 with 166 supporters.
Although most tax-exempt organizations must file an annual information return (form 990) with the IRS, churches are explicitly excluded from this requirement by IRC section 6033. Still, they may have some potential reporting and taxation obligations, such as unrelated business income taxes (UBIT) and employment taxes.
Since 1970 churches have been subject to taxes on any business income that is not substantially related to the exempt purposes. Those with unrelated business gross taxable income of $1,000 or more in a tax year are required to file Form 990-T, Exempt Organizations Business Income Tax Return, for that year. In order to be classified as an unrelated business activity generating taxable income, the activity must constitute a trade or business, be regularly carried on and not be substantially related to the church’s exempt purpose. Note that using the proceeds of the activity for exempt purposes does not make the activity related to the exempt purpose. Income from advertising in church periodicals, magazines, other publications and Web sites; gaming activities such as pull-tabs and raffles; sale of merchandise unless substantially all of the merchandise was donated; and rentals of parking lots are all income subject to the unrelated business income tax. Rental of real property; dividends, interest, annuities and other investment income unless derived from debt-financed property; and gains and losses from the disposition of investment property are not subject to the unrelated business income tax.
Note that the $1,000 standard is applied to gross income. So if gross receipts were at least $1,000 the church must file form 990-T with the IRS no later than the 15th day of the fifth month after the organization’s accounting period ends. This is true even if it had incurred enough expenses to have no taxable income.
The income from activities that meet the three previously mentioned criteria still may not be subject to tax if “substantially all of the work in operating the trade or business is performed by volunteers, the activity is conducted by the organization primarily for the convenience of its members or the trade or business involves the selling of merchandise substantially all of which was donated” (Publication 1828).
Even tax-exempt organizations must withhold income tax from the wages of employees. However, special rules apply to Social Security and Medicare taxes for clergy. Because of the complexity of payroll tax rules, many churches fail to correctly report payroll taxes. They are exempt, however, from federal unemployment taxes on all employees.
Clergy . Ordained, commissioned or licensed clergy performing services in the exercise of ministry are treated differently from other employees by the tax code. Clergy who are subject to the control of the religious body are considered employees. Three unique situations apply to clergy employees.
First, even though clergy may be employees for federal income tax purposes, they are always self-employed for Social Security purposes. One common mistake churches make is to consider a clergyperson an employee for Social Security tax purposes, withhold federal income tax and FICA tax and pay this amount along with the withholdings of other employees.
Second, an officially designated housing allowance or the fair rental value of a home provided to a clergyperson is excluded from his or her income for income tax purposes but not for self-employment tax purposes. The religious body must officially designate the amount of the housing allowance prior to payment for such allowance. Generally, the local congregation is required to make the designation.
Third, a clergyperson’s wages are exempt from income tax withholding. However, a clergyperson may enter into a voluntary withholding agreement with the religious body that can be terminated at any time by either party. In this event the religious body may withhold not only income taxes but also estimated self-employment taxes. The religious body should report this amount on form 941 as additional income taxes withheld and not as Social Security or Medicare taxes. The amount withheld is then used as a credit against both the federal income tax and the self-employment tax on the clergyperson’s income tax return. Voluntarily withholding taxes eliminates the need for the clergyperson to make estimated tax payments and is considered a timely payment of income tax and self-employment tax, thus avoiding any late-payment penalties for quarterly estimated tax.
The resulting reporting requirements by religious bodies for clergypersons are as follows:
W-2s should be provided to clergypersons and transmitted to the IRS with the transmittal form W-3 if the clergyperson is considered an employee for income tax purposes. Only taxable wages and reimbursements made under a nonaccountable plan are included in box 1 of the form W-2. The housing allowance amount is not included in this box; it is generally reported in box 14 of the W-2. All of the voluntary withholding is shown box 2 of the W-2. No amounts are shown in boxes 3 and 5, Social Security and Medicare wages.
|The CPA should
Help the organization determine whether it is a church or other religious organization. Special benefits apply to churches.
Review the requirement for tax-exempt status, and help the church comply with the requirements.
Be sure any corporation sole is not designed to hide assets or evade income taxes and is for the benefit of a legitimate religious organization.
Advise churches with unrelated business income to file the proper income tax returns.
Help churches file the proper employment tax returns for ministers and other employees.
Help churches file the proper form 1099s for nonemployees.
Help churches file other forms when required: for example, certificate of racial nondiscrimination (form 5578) and written acknowledgement of contributions.
Help churches maintain proper records to support tax-exempt status and maintain proper books and records for all required reporting.
1099s should be provided to clergypersons who are treated as self-employed for income tax purposes. However, it should be noted that in most cases the IRS considers clergypersons employees for income tax purposes.
Other employees. Religious institutions are required to withhold income taxes from the wages of nonclergy employees just as for any other employer. They are required to withhold Social Security and Medicare taxes for any employee paid $108.28 or more during the calendar year and to pay the employer’s portion of these taxes unless they receive a special exemption.
The Tax Reform Act of 1984 allows a religious body to elect a special exemption from the employer’s share of FICA taxes if it opposes such taxes on religious grounds. The election, on form 8274, must be made by the day before the due date of the first required form 941. Since clergyperson’s wages are not subject to withholding for either income tax or FICA, the deadline can expire only if there is at least one nonclergy employee. The IRS does not allow exceptions to this deadline. If a religious body elects this exemption in a timely manner then all its employees are treated as self-employed for Social Security and Medicare tax purposes; the employees must pay the self-employment tax and will normally have to make estimated tax payments.
Nonemployees . Payment of $600 or more in a calendar year by any “person engaged in a trade or business” to any nonemployee or partnership (not a corporation) in furtherance of that trade or business requires the filing of a form 1099-MISC. What about recipients of benevolent gifts from the church? Are these amounts to be reported on 1099s? According to revenue ruling 2003-12, to the extent the distribution is consistent with the tax-exempt purpose, a 1099 is not required. These recipients have performed no service.
To assess whether a person is an employee or nonemployee, the tax preparer can use IRS Publication 15-A, Employer’s Supplemental Tax Guide, or file form SS-8 to have the IRS make the determination. While the IRS maintains that substantial penalties may be assessed against organizations that fail to properly withhold employment taxes, section 530 of the Revenue Act of 1978 provides considerable protection for the organization against excessive penalties. However, these protections do not extend to the workers. A member of the clergy who improperly reports earnings as self-employed earnings may face considerable penalties if the IRS subsequently reclassifies him or her as an employee.
Religious Organizations: Key Accounting, Tax, and Financial Issues (# 732561JA).
To order go to www.cpa2biz.com or call the Institute at 888-777-7077.
Church & Clergy Tax Guide by R. Hammer (2004 ed.), Christian Ministry Resources, Matthews, North Carolina, 2003.
Internal Revenue Manual, Part 7, Chapter 25, Exempt Organizations Determination Manual.
Internal Revenue Manual, Part 7, Chapter 27, Exempt Organizations Tax Manual.
IRS Publication 517, Social Security and Other Information for Members of the Clergy and Religious Workers.
IRS Publication 525, Taxable and Nontaxable Income.
IRS Publication 557, Tax-Exempt Status for Your Organization.
IRS Publication 598, Tax on Unrelated Business Income of Exempt Organizations.
IRS Publication 1771, Charitable Contributions: Substantiation and Disclosure Requirements.
IRS Publication 1828, Tax Guide for Churches and Religious Organizations.
IRS Publication 4302, A Charity’s Guide to Car Donations (being revised).
www.clergysupport.com provides useful information for churches.
Note: All IRS publications can be found at www.irs.gov .
Religious bodies that operate, supervise or control a private school including a preschool or kindergarten, must file a certificate of racial nondiscrimination, form 5578, each year with the IRS. This is required only if the organization doesn’t file a form 990.
Donors should receive written acknowledgement of any contribution of $250 or more and any quid pro quo contributions in which the donor received goods or services in exchange for contributions of $75 or more in order for them to deduct the contribution on their tax returns. On the quid pro quo contribution, the donor may deduct only the amount of the contribution that is in excess of the fair value of any goods or services received, unless the goods or services were of insubstantial value or of only intangible religious benefit. A ticket to a prayer meeting is of intangible value; a ticket to the Super Bowl is not.
All tax-exempt organizations, whether officially recognized or not, are required to maintain records of employees and donors, books of accounting and other records necessary to justify their claim for exemption in the event of an audit or to accurately file federal tax and information returns. The organization must keep all employment tax records for at least four years after the date the tax is due or is paid, whichever is later. Generally, records that support an item, income or deduction must be kept for three years from the return filing date or tax payment date, whichever is later. If unreported income is more than 25% of the gross income, the period becomes six years. If there is fraud involved or if no required return is filed, there is no statute of limitations.