IRS Private Letter Rulings 200435019, 200435020, 200435021, 200435022
Article summary
. In a series of four rulings published in August of 2004 the IRS for the first time assessed “intermediate sanctions” against a pastor as a result of “excess benefits” paid to him (and members of his family) by his church. Intermediate sanctions are substantial excise taxes the IRS can impose on persons who receive “excess benefits” from a tax-exempt organization. The IRS concluded that a pastor’s personal use of church assets (vehicles, cell phones, etc.) and nonaccountable reimbursements (not supported by adequate documentation of business purpose) that a church pays its pastor, are “automatic excess benefits” resulting in intermediate sanctions, regardless of the amount involved, unless they are reported as taxable income by the church on the pastor’s W-2, or by the pastor on Form 1040, for the year in which the benefits are provided. This is a stunning interpretation of the tax code and regulations that will directly affect the compensation practices of many churches, and expose some church staff members to intermediate sanctions. This article will explain intermediate sanctions, summarize the recent IRS rulings, and assess their relevance to pastors and church compensation practices.
Church compensation practices came under close scrutiny by the IRS in a series of four private letter rulings issued in August of 2004. These rulings represent a major tax development that should be understood by every pastor and church treasurer. Unfamiliarity with these rulings will subject pastors to potentially substantial penalties.
The bottom line is this—the IRS concluded that the personal use of church property (vehicles, homes, computers, credit cards, cell phones, etc.) by a pastor and members of his family, and “nonaccountable” payments or reimbursements by the church of business and personal expenses incurred by the pastor and members of his family, were “automatic excess benefits” resulting in intermediate sanctions, regardless of the amount involved, because they were not reported as taxable income by the church on the pastor’s W-2 or by the pastor on his Form 1040 for the year in which the benefits were provided.
Intermediate sanctions are substantial penalties in the form of excise taxes that the IRS can assess against “insiders” who are paid an “excess benefit” by a church or other tax-exempt organization. In the past, such penalties focused entirely on benefits that were unreasonable in amount. The new IRS interpretation exposes any pastor to intermediate sanctions whose church provides a benefit that is not reported as taxable income by either the church or pastor in the year the benefit is provided. Such benefits may be in the form of loans, nonaccountable expense reimbursements, sales of church property at a price that is below market value, or use of church vehicles and other forms of property for personal purposes.
These rulings will impact the compensation practices of many churches, and expose pastors and church board members to potentially strict penalties for certain transactions that are not timely reported as taxable income. It is essential for pastors, church treasurers, and church board members to clearly understand the IRS rulings and their application to church compensation practices. This article will provide church leaders with vital information about this significant development.
In order to understand the recent IRS rulings church leaders must have some familiarity with the concept of intermediate sanctions and an article entitled “Automatic Excess Benefit Transactions under Section 4958” that appeared in the IRS 2004 Continuing Professional Education text. As a result, this feature article is divided into the following four parts:
Part 1: Intermediate Sanctions
Part 2: IRS Article on “Automatic Excess Benefit Transactions”
Part 3: Four Recent IRS Rulings
Part 4: Application to Church Compensation Practices
Part 1: Intermediate Sanctions
Caution. Churches often provide benefits to their senior pastor besides salary. These benefits may include personal use of church property; payment of personal expenses; and reimbursement of business or personal expenses under a nonaccountable arrangement. Often, pastors and church treasures are unaware that these benefits must be valued and reported as taxable income on the pastor’s W-2. This common practice will expose the pastor, and possibly church board members, to substantial excise taxes since the IRS now views these benefits as “automatic” excess benefits resulting in intermediate sanctions unless the benefit was reported as taxable income by the church or pastor in the year it was provided. The lesson is clear. Sloppy church accounting practices will expose ministers, and in some cases church board members, to intermediate sanctions in the form of substantial excise taxes. As a result, it is essential for pastors and church treasurers to be familiar with the concept of automatic excess benefits so that these penalties can be avoided.
Section 501(c)(3) of the tax code exempts churches and most other religious organizations and public charities from federal income taxation. There are five conditions that must be met to qualify for exemption. One of them is that none of the organization’s assets “inures” to the private benefit of an individual other than as reasonable compensation for services rendered. Churches and other tax-exempt organizations that pay unreasonable compensation to an employee are violating one of the requirements for exemption and are placing their exempt status in jeopardy. However, the IRS has been reluctant to revoke the tax-exempt status of charities that pay unreasonable compensation since this remedy is so harsh and punishes the entire organization rather than the individuals who benefited from the transaction. For example, should an entire public university lose its tax-exempt status because the head football coach is paid millions of dollars?
For many years, the IRS asked Congress to provide a remedy other than outright revocation of exemption that it could use to combat excessive compensation paid by exempt organizations. In 1996, Congress responded by enacting section 4958 of the tax code.
Section 4958 empowers the IRS to assess “intermediate sanctions” in the form of substantial excise taxes against insiders (called “disqualified persons”) who benefit from an “excess benefit transaction.” Section 4958 also allows the IRS to assess excise taxes against a charity’s board members who approved an excess benefit transaction. These excise taxes are called “intermediate sanctions” because they represent a remedy that the IRS can apply short of revocation of a charity’s exempt status.
While revocation of exempt status remains an option whenever a tax-exempt organization enters into an excess benefit transaction with a disqualified person, it is less likely that the IRS will pursue this remedy now that intermediate sanctions are available.
Who is a “disqualified person”?
Since intermediate sanctions apply only to disqualified persons (and in some cases managers), it is important for church leaders to be familiar with this term. The regulations provide helpful guidance. They define a disqualified person as 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.
substantial influence
The income tax regulations specify that a person who holds any of the following responsibilities is in a position to exercise substantial influence over the affairs of a tax-exempt organization:
• Voting members of governing body. Any individual serving on the governing body of the organization who is entitled to vote on any matter over which the governing body has authority.
• Presidents, chief executive officers, or chief operating officers. This category includes 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. A person who serves as president, chief executive officer, or chief operating officer has this ultimate responsibility unless the person demonstrates otherwise.
• Treasurers and chief financial officers. This category includes any person who, regardless of title, has ultimate responsibility for managing the finances of the organization. A person who serves as treasurer or chief financial officer has this ultimate responsibility unless the person demonstrates otherwise. If this ultimate responsibility resides with two or more individuals who may exercise the responsibility in concert or individually, then each individual is in a position to exercise substantial influence over the affairs of the organization.
family members
The term “disqualified person” includes family members of a disqualified person. The income tax regulations define family members as:
- spouses
- brothers or sisters (by whole or half blood)
- spouses of brothers or sisters (by whole or half blood)
- ancestors
- children
- grandchildren
- great grandchildren
- spouses of children, grandchildren, and great grandchildren
an exception
The income tax regulations specify that some persons are not in a position to exercise substantial influence over the affairs of a tax-exempt organization, including employees who receive compensation or other benefits from an exempt organization of less than the amount required of a “highly compensated employee” under section 414(q) of the tax code ($90,000 for 2004) and who do not meet the definitions of family member or substantial influence as defined in the preceding paragraphs.
• Example. Pastor T is senior pastor of a church, and serves as president of the corporation and a member of the board (with the right to vote). Pastor T’s church salary for the current year is $50,000. Since Pastor T serves as both president and a member of the board, he is not automatically exempted from the definition of a disqualified person even though he is not a “highly compensated employee.” As a result, he will be subject to intermediate sanctions if the church pays him excessive compensation. However, Pastor T’s current level of compensation is not excessive. In summary, while he is a disqualified person, he is not subject to intermediate sanctions because his compensation is reasonable.
• Example. Pastor C is an assistant pastor. He does not serve on the church board and is not an officer of the church. His church compensation for this year is $40,000. In addition, the church board is considering a gift of the parsonage to Pastor C. The parsonage has a current value of $75,000 (and is debt free). The board is concerned that the gift of the parsonage to Pastor C will expose him to intermediate sanctions. They do not need to be concerned. It is true that Pastor C will be a highly compensated employee if the parsonage is given to him, since he will have compensation of more than $90,000. But this in itself does not make him a disqualified person. The regulations require that he be in a position to exercise substantial influence over the affairs of the church. An assistant pastor who is neither an officer nor member of the board probably does not meet this test. Since Pastor C is not a disqualified person, he is not subject to intermediate sanctions.
• Example. Same facts as the previous example, except that Pastor C is a senior pastor who serves on the church board (with the right to vote). Under these circumstances, Pastor C will be deemed a disqualified person because of his status as a church board member. This will expose him to intermediate sanctions if he receives an excess benefit from the church. It is unlikely that the compensation paid to Pastor C would be deemed excessive, especially if he pastors a larger church. See the 2005 Compensation Handbook for Church Staff by Richard Hammar and James Cobble, published by Church Law & Tax Report.
Excise taxes
Intermediate sanctions consist of the following three excise taxes:
(1) tax on disqualified persons
A disqualified person who benefits from an excess benefit transaction is subject to an excise tax equal to 25% of the amount of the “excess benefit” (the amount by which actual compensation exceeds the fair market value of services rendered). This tax is paid by the disqualified person directly, not by his or her employer.
(2) additional tax on disqualified persons
If the 25% excise tax is assessed against a disqualified person, and he or she fails to “correct” the excess benefit within the “taxable period” (defined below) the IRS can assess an additional tax of 200% of the excess benefit. Section 4958 specifies that the disqualified person can “correct” the excess benefit transaction by “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” must occur by the earlier of the date the IRS mails a notice informing the disqualified person that he or she owes the 25% tax, or the date the 25% tax is actually assessed.
(3) tax on organization managers
If the IRS assesses the 25% tax against a disqualified person, it is permitted to impose an additional 10% tax on any “organization manager” (any officer, director, or trustee) who participates in an excess benefit transaction knowing it is such a transaction, unless the manager’s participation “is not willful and is due to reasonable cause.” This tax is limited to a maximum of $10,000 per manager (but the total tax on all mangers cannot exceed $10,000).
“Correcting” an excess benefit transaction
Section 4958 specifies that a disqualified person who receives excess compensation is subject to an excise tax equal to 25% of the amount of compensation in excess of a reasonable amount. Further, if the excess benefit is not “corrected,” the disqualified person is liable for a tax of 200% of the excess benefit. The correction must occur within the “taxable period.”
The tax code defines the “taxable period” as “the period beginning with the date on which the transaction occurs and ending on the earliest [sic] of (1) the date of mailing a notice of deficiency under section 6212 [of the tax code] with respect to the [25% excise tax] or (2) the date on which the [25% excise tax] is assessed.”
How can a disqualified person “correct” an excess benefit transaction? The regulations answer this question as follows:
An excess benefit transaction is corrected by undoing the excess benefit to the extent possible, and taking any additional measures necessary to place the tax-exempt organization involved in the excess benefit transaction in a financial position not worse than that in which it would be if the disqualified person were dealing under the highest fiduciary standards.
A disqualified person corrects an excess benefit only by making a payment in cash or cash equivalents (excluding payment by a promissory note, to the tax-exempt organization equal to the correction amount).
• Example. A pastor is a member of his church’s governing board. Last year the pastor was paid a monthly car allowance of $400, and was not required to substantiate any business use of his car. Neither the church nor the pastor reported the allowances as taxable income. The pastor recently learned that these allowances may constitute automatic excess benefits exposing him to substantial excise taxes. He is unable to send the church a check for $4,800, so he drafts a promissory note in which he promises to pay the church $4,800 within one year without interest. The IRS will not consider this promissory note to be a correction of the excess benefit.
A disqualified person may, with the agreement of the tax-exempt organization, make a correction by returning property previously transferred in the excess benefit transaction. In this case, the disqualified person is treated as making a payment equal to the lesser of (1) the fair market value of the property determined on the date the property is returned to the organization; or (2) the fair market value of the property on the date the excess benefit transaction occurred.
The “correction amount” with respect to an excess benefit transaction equals the sum of the excess benefit and interest on the excess benefit.
abatement of the penalty
If a disqualified person corrects an excess benefit transaction during the taxable period, the 25% and 200% excise taxes are “abated” as follows:
• 25% excise tax. The 25% excise tax is abated only if the disqualified person can establish that (1) the excess benefit transaction was due to “reasonable cause,” and (2) was not due to “willful neglect.” For this purpose, “reasonable cause” means exercising “ordinary business care and prudence.” “Not due to willful neglect” means that the receipt of the excess benefit was not due to the disqualified person’s conscious, intentional or voluntary failure to comply with section 4958, and that the noncompliance was not due to conscious indifference. Disqualified persons who cannot prove both of these requirements will be liable for the 25% excise tax even though they corrected the excess benefit transaction and paid federal income tax on the benefit as additional compensation.
• 200% excise tax. The 200% excise tax under section 4958 is automatically abated.
• Example. A church pays its pastor a salary that the board later determines to have resulted in an excess benefit of $100,000. The board persuades the pastor to “correct” the arrangement by returning the excess amount to the church. This is not enough to “correct” the excess benefit transaction, and so the pastor is exposed to the 200% excise tax ($200,000). The regulations clarify that a “correction” involves more than a return of the excess benefit. The recipient of the excess benefit must repay the church or other tax exempt organization “the sum of the excess benefit and interest on the excess benefit.” In this example, this means that the pastor must pay the church an amount sufficient to compensate it for the earnings it would have received on the excess amount had it not been paid to the pastor.
What is an excess benefit?
Section 4958(c)(1)(A) of the tax code defines an excess benefit transaction as follows:
The term “excess benefit transaction” means any transaction in which an economic benefit is provided by an applicable tax-exempt organization directly or indirectly to or for the use of any disqualified person if the value of the economic benefit provided exceeds the value of the consideration (including the performance of services) received for providing such benefit. For purposes of the preceding sentence, an economic benefit shall not be treated as consideration for the performance of services unless such organization clearly indicated its intent to so treat such benefit.
Stated simply, an excess benefit transaction is one in which the value of a “benefit” provided to an insider exceeds the value of the insider’s services. The excess benefit can be an inflated salary, but it can also be any other kind of transaction that results in an excess benefit. Here are three examples:
(1) Sale of an exempt organization’s assets to an insider for less than market value.
(2) Use of an exempt organization’s property for personal purposes.
(3) Payment of an insider’s personal expenses.
Section 4958 states that certain benefits are not considered in determining if a disqualified person has received an excess benefit. Such benefits include “expense reimbursement payments pursuant to an accountable plan.”
Reasonable compensation
An excess benefit occurs when an exempt organization pays a benefit to an insider in excess of the value of his or her services. In other words, an excess benefit is a benefit that is paid in excess of “reasonable compensation” for services rendered. The income tax regulations explain the concept of reasonable compensation as follows: “The value of services is the amount that would ordinarily be paid for like services by like enterprises (whether taxable or tax-exempt) under like circumstances (i.e., reasonable compensation).”
Compensation for purposes of determining reasonableness under section 4958 includes “all economic benefits provided by a tax-exempt organization in exchange for the performance of services.” These include, but are not limited to
(1) all forms of cash and noncash compensation, including salary, fees, bonuses, severance payments, and deferred and noncash compensation, and
(2) all other compensatory benefits, whether or not included in gross income for income tax purposes, including payments to plans providing medical, dental, life insurance, severance pay, and disability benefits, and both taxable and nontaxable fringe benefits (other than fringe benefits described in section 132), including expense allowances or reimbursements (other than expense reimbursements pursuant to an accountable plan) and the economic benefit of a below-market loan.
Nonaccountable expense reimbursements
The income tax regulations specify that certain benefits are disregarded under section 4958, meaning that they are not taken into account in determining if an excess benefit transaction has occurred that would trigger intermediate sanctions. The benefits not taken into account include “expense reimbursement payments pursuant to accountable plans.”
Under an accountable reimbursement plan, an employer reimburses expenses of an employee only after receiving “adequate records” substantiating the amount, date, location, and business purpose of each reimbursed expense (including receipts for each expense of $75 or more). These strict substantiation requirements apply to all local transportation expenses (including the business use of a car); out-of-town travel expenses (including travel, lodging, and meals); entertainment; business gifts; personal computers; and cell phones. Other business expenses can be substantiated under an accountable plan with slightly less detail.
An employer’s reimbursement of employee expenses that does not satisfy the strict requirements of an accountable plan is considered “nonaccountable.” Such reimbursements constitute taxable income for income tax reporting purposes. But they also may constitute an excess benefit transaction triggering intermediate sanctions. This issue was addressed by the IRS in an article in the January 2004 edition of its “2004 Continuing Professional Education” text. This article for the first time recognizes the concept of “automatic” excess benefit transactions that can result in intermediate sanctions regardless of whether they are excessive or unreasonable in amount. This major development is discussed later in this article.
The presumption of reasonableness
The income tax regulations clarify that compensation is presumed to be reasonable, and a transfer of property, or the right to use property, is presumed to be at fair market value, if the following three conditions are satisfied.
(1) the compensation arrangement or the terms of the property transfer are approved in advance by an authorized body of the tax-exempt organization composed entirely of individuals who do not have a conflict of interest (defined below) with respect to the compensation arrangement or property transfer;
(2) the authorized body obtained and relied upon appropriate “comparability data” prior to making its determination, as described below; and
(3) the authorized body adequately documented the basis for its determination at the time it was made, as described below.
If these three requirements are met, the IRS may rebut the presumption of reasonableness if it “develops sufficient contrary evidence to rebut the … comparability data relied upon by the authorized body.”
There are some important terms here that are further defined by the regulations, as noted below.
authorized body of the tax-exempt organization
An authorized body means “the governing body (i.e., the board of directors, board of trustees, or equivalent controlling body) of the organization, a committee of the governing body … or other parties authorized by the governing body of the organization to act on its behalf by following procedures specified by the governing body in approving compensation arrangements or property transfers.”
An individual is not included on the authorized body when it is reviewing a transaction if that individual meets with other members only to answer questions, and otherwise recuses himself or herself from the meeting and is not present during debate and voting on the compensation arrangement or property transfer.
A member of the authorized body does not have a conflict of interest with respect to a compensation arrangement or property transfer only if the member:
(1) is not a disqualified person participating in or economically benefiting from the compensation arrangement or property transfer, and is not a member of the family of any such disqualified person;
(2) is not in an employment relationship subject to the direction or control of any disqualified person participating in or economically benefiting from the compensation arrangement or property transfer;
(3) does not receive compensation or other payments subject to approval by any disqualified person participating in or economically benefiting from the compensation arrangement or property transfer;
(4) has no material financial interest affected by the compensation arrangement or property transfer; and
(5) does not approve a transaction providing economic benefits to any disqualified person participating in the compensation arrangement or property transfer, who in turn has approved or will approve a transaction providing economic benefits to the member.
comparability data
An authorized body has appropriate data as to comparability if, given the knowledge and expertise of its members, it has sufficient information to determine if the compensation arrangement is reasonable or the property transfer is at fair market value.
In the case of compensation, relevant information includes, but is not limited to:
(1) compensation levels paid by similarly situated organizations, both taxable and tax-exempt, for functionally comparable positions;
(2) the availability of similar services in the geographic area of the applicable tax-exempt organization;
(3) current compensation surveys compiled by independent firms; and
(4) actual written offers from similar institutions competing for the services of the disqualified person.
In the case of property, relevant information includes, but is not limited to, current independent appraisals of the value of all property to be transferred; and offers received as part of an open and competitive bidding process.
For organizations with annual gross receipts (including contributions) of less than $1 million reviewing compensation arrangements, the authorized body will be considered to have appropriate data as to comparability if it has data on compensation paid by three comparable organizations in the same or similar communities for similar services. An organization may calculate its annual gross receipts based on an average of its gross receipts during the three prior taxable years.
IRS regulations contain the following examples.
• Example. Z is a university that is an applicable tax-exempt organization for purposes of section 4958. Z is negotiating a new contract with Q, its president, because the old contract will expire at the end of the year. In setting Q’s compensation for its president at $600x per annum, the executive committee of the Board of Trustees relies solely on a national survey of compensation for university presidents that indicates university presidents receive annual compensation in the range of $100x to $700x; this survey does not divide its data by any criteria, such as the number of students served by the institution, annual revenues, academic ranking, or geographic location. Although many members of the executive committee have significant business experience, none of the members has any particular expertise in higher education compensation matters. Given the failure of the survey to provide information specific to universities comparable to Z, and because no other information was presented, the executive committee’s decision with respect to Q’s compensation was not based upon appropriate data as to comparability.
• Example. The facts are the same as the previous example, except that the national compensation survey divides the data regarding compensation for university presidents into categories based on various university-specific factors, including the size of the institution (in terms of the number of students it serves and the amount of its revenues) and geographic area. The survey data shows that university presidents at institutions comparable to and in the same geographic area as Z receive annual compensation in the range of $200x to $300x. The executive committee of the Board of Trustees of Z relies on the survey data and its evaluation of Q’s many years of service as a tenured professor and high-ranking university official at Z in setting Q’s compensation at $275x annually. The data relied upon by the executive committee constitutes appropriate data as to comparability.
• Example. X is a tax-exempt hospital that is an applicable tax-exempt organization for purposes of section 4958. Before renewing the contracts of X’s chief executive officer and chief financial officer, X’s governing board commissioned a customized compensation survey from an independent firm that specializes in consulting on issues related to executive placement and compensation. The survey covered executives with comparable responsibilities at a significant number of taxable and tax-exempt hospitals. The survey data are sorted by a number of different variables, including the size of the hospitals and the nature of the services they provide, the level of experience and specific responsibilities of the executives, and the composition of the annual compensation packages. The board members were provided with the survey results, a detailed written analysis comparing the hospital’s executives to those covered by the survey, and an opportunity to ask questions of a member of the firm that prepared the survey. The survey, as prepared and presented to X’s board, constitutes appropriate data as to comparability.
• Example. The facts are the same as the previous example, except that one year later, X is negotiating a new contract with its chief executive officer. The governing board of X obtains information indicating that the relevant market conditions have not changed materially, and possesses no other information indicating that the results of the prior year’s survey are no longer valid. Therefore, X may continue to rely on the independent compensation survey prepared for the prior year in setting annual compensation under the new contract.
• Example. W is a local repertory theater and an applicable tax-exempt organization for purposes of section 4958. W has had annual gross receipts ranging from $400,000 to $800,000 over its past three taxable years. In determining the next year’s compensation for W’s artistic director, the board of directors of W relies on data compiled from a telephone survey of three other unrelated performing arts organizations of similar size in similar communities. A member of the board drafts a brief written summary of the annual compensation information obtained from this informal survey. The annual compensation information obtained in the telephone survey is appropriate data as to comparability.
documentation
For a decision to be documented adequately, the written or electronic records of the authorized body must note:
(1) The terms of the transaction that was approved and the date it was approved;
(2) the members of the authorized body who were present during debate on the transaction that was approved and those who voted on it;
(3) the comparability data obtained and relied upon by the authorized body and how the data was obtained; and
(4) any actions taken with respect to consideration of the transaction by anyone who is otherwise a member of the authorized body but who had a conflict of interest with respect to the transaction.
• Key point. The regulations state that “the fact that a transaction between a tax-exempt organization and a disqualified person is not subject to the presumption of reasonableness neither creates any inference that the transaction is an excess benefit transaction, nor exempts or relieves any person from compliance with any federal or state law imposing any obligation, duty, responsibility, or other standard of conduct with respect to the operation or administration of any applicable tax-exempt organization.”
• Example. A parachurch ministry’s board includes the president. If the IRS later asserts that the president was paid excessive compensation, the president will not be able to rely on the presumption of reasonableness because of his presence on the board. However, if he recuses himself from the board meeting in which his compensation is discussed (and so is not present for the debate and voting on the compensation arrangement), he may not have a “conflict of interest” that would preclude the presumption of reasonableness.
• Example. Same facts as the previous example. The president does not serve on the board, but his wife does. The president recuses himself from the board meeting in which his compensation is determined, but his wife does not. The president will not be able to rely on the presumption of reasonableness, because one board member (the wife) is related to the president, and she did not recuse herself from the meeting that addressed her husband’s compensation.
• Example. A church with 500 members and an annual budget of $1 million paid its senior pastor compensation of $200,000 in 2004. The pastor participated in the board meeting in which his compensation was determined. The church board is concerned that the pastor’s compensation may be excessive. They begin doing “salary comparisons” of other churches and businesses in the area with a similar membership or budget. Such efforts will serve no purpose if the board is attempting to qualify the pastor for the rebuttable presumption of reasonableness. The pastor’s presence on the board, and his participation in the meeting in which his compensation was determined, disqualify him for the presumption of reasonableness. However, salary surveys will be relevant in determining whether or not the pastor’s compensation is excessive.
• Example. Same facts as the previous example, except that the pastor recused himself from the board meeting in which his compensation was determined. The board’s efforts to obtain “salary comparisons” may be helpful. If the board determines that “similarly situated organizations, both taxable and tax exempt”, are paying persons in a “functionally equivalent position” a similar amount of compensation, then this may establish a rebuttable presumption that the pastor’s compensation is reasonable. This assumes that the pastor’s recusing himself from the board meeting in which his compensation was determined avoided any “conflict of interest”.
• Example. Same facts as the previous example. Assume that the board learns that the average annual compensation paid to senior pastors by 20 “similarly situated” churches in the same area is $75,000. The board also determines that the average annual compensation paid by 10 local businesses with annual revenue of $1 million is $100,000. The results of the board’s salary surveys clearly will not support the rebuttable presumption of reasonableness.
• Example. A church pays its senior pastor annual compensation of $75,000 for 2004. The pastor serves as a member of the church’s governing board. In 2004 the church board also provides the pastor with a new car (with a value of $25,000) in recognition of 30 years of service. The pastor recused himself from the board meetings in which his salary and the gift were approved. The gift of the car is fully taxable, and so the pastor’s total compensation for 2004 will be $100,000. The board obtains a copy of the annual Compensation Handbook for Church Staff, written by Richard Hammar and James Cobble, and determines that senior pastors in “similarly situated” churches are paid an average of $85,000 per year. This information may be used to support a rebuttable presumption of reasonableness, since the pastor’s compensation (including the gift of the car) is not substantially above the average. This assumes that the pastor’s recusing himself from the board meeting in which his compensation was determined avoided any “conflict of interest”.
Tip. The intermediate sanctions law creates a presumption that a minister’s compensation package is reasonable if approved by a church board that relied upon objective “comparability” information, including independent compensation surveys by nationally recognized independent firms. The most comprehensive compensation survey for church workers is the annual Compensation Handbook for Church Staff, written by Richard Hammar and James Cobble, and available from the publisher of this tax guide.
Tax on managers
“Managers” who approve an excess benefit transaction are subject to an excise tax equal to 10% of the amount of the excess benefit’up to a maximum of $10,000. The regulations provide the following clarifications:
(1) A “manager” is defined as “any officer, director, or trustee of such organization, or any individual having powers or responsibilities similar to those of officers, directors, or trustees of the organization, regardless of title.”
(2) A manager must participate in the decision to pay excessive compensation to a disqualified person in order to be subject to the 10% excise tax. The regulations specify that a manager will not be considered to have participated in an excess benefit transaction if he or she “opposed such transaction in a manner consistent with the fulfillment of the manager’s responsibilities to the applicable tax exempt organization.”
(3) The regulations specify that managers can avoid the excise tax if they rely on the advice of legal counsel “expressed in a reasoned written legal opinion that a transaction is not an excess benefit transaction.”
(4) The regulations clarify that the tax that must be paid by participating managers for any one excess benefit transaction cannot exceed $10,000 in the aggregate. In other words, each manager is not individually liable for the full $10,000 with respect to the same transaction.
• Example. A church board gives a retiring pastor the church parsonage (having a value of $150,000). The board members later learn about intermediate sanctions, and are concerned that they may each be liable for up to $10,000 as managers. The regulations clarify that the board members will not individually be liable for the 10% excise tax (up to $10,000). Rather, they will collectively be liable for an excise tax (as managers) of 10% of the amount of the excess benefit up to a maximum tax of $10,000. The total tax assessed for this single transaction will be allocated to the board members who participated in the decision.
Effect on tax exempt status
The regulations caution that churches and other charities are still exposed to loss of their tax exempt status if they pay excessive compensation. The fact that such compensation arrangements may trigger intermediate sanctions does not necessarily protect the organization’s tax exempt status from attack.
• Example. In one of the first court cases to address intermediate sanctions, the Tax Court concluded, “The intermediate sanction regime was enacted in order to provide a less drastic deterrent to the misuse of a charity than revocation of that charity’s exempt status …. Although the imposition of [intermediate sanctions] as a result of an excess benefit transaction does not preclude revocation of the organization’s tax-exempt status, the legislative history indicates that both a revocation and the imposition of intermediate sanctions will be an unusual case.” Caracci v. Commissioner, 118 T.C. 379 (2002).
Application to churches
The regulations confirm that intermediate sanctions apply to churches, but they specify that the protections of the “Church Audit Procedures Act” apply. The Church Audit Procedures Act imposes detailed limitations on IRS examinations of churches. These limitations are explained fully in Chapter 12, Section A.8, of this tax guide.
• Key point. The IRS Tax Guide for Churches specifies that the protections of the Church Audit Procedures Act “will be used in initiating and conducting any inquiry or examination into whether an excess benefit transaction has occurred between a church and an insider.”