Churches and other 501(c)(3) organizations are subject to unique federal tax rules covering compensation. Specifically, 501(c)(3) organizations are prohibited under federal tax law from paying compensation above that which is “reasonable” to their leaders. Although situations in which churches pay excessive compensation are rare, these regulations should nevertheless be taken into consideration.
“In a for-profit business, such as a corporation, if the IRS determines there is unreasonable compensation, the deduction for the unreasonable portion of the compensation is disallowed and the business goes on. More taxes will be paid, but the business still exists,” said Elaine Sommerville, a CPA focusing primarily on tax compliance aspects of nonprofit organizations.
However, if the IRS determines a church paid excessive compensation, the church could lose its tax-exempt status, explained Sommerville. Or the recipient of the unreasonable compensation could be forced to return the portion deemed to be “unreasonable” to the church, owe the IRS an intermediate sanction of 25 percent, and if not corrected, be assessed an additional penalty of 200 percent. Those who authorized the payment of the excessive compensation may individually be assessed a penalty of 10 percent of the unreasonable amount.
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