Forgiving Our Debtors May Jeopardize Tax-Exempt Status

What a church should know before forgiving its debtors.

Church Finance Today

“Forgiving Our Debtors” May Jeopardize Tax-Exempt Status

What a church should know before forgiving its debtors.

Background. Churches and other organizations that are exempt from federal income taxes must comply with several requirements in order to maintain their exempt status. One of these requirements is that none of the exempt organization’s resources “inures” to the benefit of a private individual—other than as reasonable compensation for services rendered or in direct furtherance of the organization’s exempt functions. Does an exempt organization’s forgiveness of a bad debt constitute prohibited “inurement”? That was the issue presented to a federal court in a recent case. While the case involved a non-religious charity, it has implications for churches and other religious organizations.

Facts. The founder of a tax-exempt charity also created a for-profit corporation. The for-profit corporation leased property from the charity, but did not pay rent in a timely manner and eventually accumulated hundreds of thousands of dollars in rental debt. The charity also “forgave” nearly $34,000 in interest owed by the for-profit corporation. The charity claimed that the interest was “forgiven” “because of the unlikelihood of repayment.” The IRS audited the charity and revoked its tax-exempt status. It concluded that the charity’s forgiveness of interest and failure to collect back rent from the for-profit corporation controlled by the charity’s founder amounted to prohibited “inurement” of the charity’s resources to the benefit of the founder. The charity appealed this ruling.

The court’s ruling. A federal court agreed with the IRS and upheld the revocation of the charity’s tax-exempt status. It noted a charity can lose its exempt status if it does not “operate exclusively” for exempt purposes, and if any part of its resources “inures” to the benefit of a private individual. The court observed:

First, the organization must “operate exclusively” for tax-exempt purposes. An organization’s tax-exempt status will not be revoked for providing “incidental” benefits while serving an exempt purpose. But a single substantial non-exempt purpose served by the organization does nullify the organization’s tax exemption regardless of the quantity or substance of its tax-exempt purposes. An organization does not operate exclusively for tax-exempt purposes if it serves a private rather than a public interest. This requirement applies to the organization’s actual, not purported, purposes.

Second, “no part of the net earnings” of the organization may “inure to the benefit of any private shareholder or individual.” “Private shareholder or individual” has been construed broadly by the courts as any person “having a personal or private interest in the activities of the organization,” including the organization’s founder and family.

These two requirements, “though separate, frequently overlap.” Failure to satisfy either requirement results in revocation of the organization’s tax-exempt status. The burden is on the organization to establish that it meets the statutory requirements for tax-exempt status.

The court concluded that the charity’s “forgiveness of the accrued interest is an example of how [its] earnings inured to private benefit,” namely to the benefit of a for-profit corporation owned by the charity’s founder.

Relevance to church treasurers. This ruling is directly relevant to any church treasurer whose church is considering the forgiveness of a debt owed to the church by anyone with a “a personal or private interest in the activities of the organization.” At a minimum this would include debts owed to the church by pastors or board members, and probably by church members as well. Often, these debts are in the form of a loan.

Key point. Churches often make loans to clergy in order to assist in the purchase of a home. In some cases the minister fails to pay the loan in full. Church treasurers and board members often do not know how to respond in such cases. This case illustrates an important point—delinquent loans should not be forgiven without careful consideration of the possible consequences to the church. In order to minimize jeopardizing the church’s exempt status, a church should not forgive a delinquent loan without, at a minimum, taking the following steps: (1) exhaust all reasonable means of collection, and (2) report the bad debt (principal and accrued interest) as income to the debtor. If the debtor is a current employee, the forgiven debt can be reported as income on the employee’s W-2. If the debtor is not an employee, use a Form 1099-MISC.

This article originally appeared in Church Treasurer Alert, August 1995.

Richard R. Hammar is an attorney, CPA and author specializing in legal and tax issues for churches and clergy.

This content is designed to provide accurate and authoritative information in regard to the subject matter covered. It is sold with the understanding that the publisher is not engaged in rendering legal, accounting, or other professional service. If legal advice or other expert assistance is required, the services of a competent professional person should be sought. "From a Declaration of Principles jointly adopted by a Committee of the American Bar Association and a Committee of Publishers and Associations." Due to the nature of the U.S. legal system, laws and regulations constantly change. The editors encourage readers to carefully search the site for all content related to the topic of interest and consult qualified local counsel to verify the status of specific statutes, laws, regulations, and precedential court holdings.

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