IRS Addresses Church Compensation Practices

Part 3 – Four Recent IRS Rulings

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 3: Four Recent IRS Rulings

In August of 2004, the IRS issued four private letter rulings that apply the principle of “automatic” excess benefit transactions to a variety of benefits that were provided by a church to its pastor and members of the pastor’s family. These rulings are discussed separately below.

Ruling #1: IRS Letter Ruling 200435019

A church was founded by a pastor (Pastor B), who has been its only pastor and who also serves as the president and a director of the church. The church’s bylaws specify that directors are appointed by Pastor B and serve until their death, disability, resignation or removal by Pastor B. The other members of the church’s board of directors are Pastor B’s wife (who also serves as secretary-treasurer), and one of his sons (who is the vice-president). Pastor B has two sons, C and D. The IRS addressed the consequences of the following transactions in this ruling:

(1) use of church credit cards by Pastor B’s son D

(2) church reimbursement of cell phone expenses incurred by Pastor B’s son D

(3) the church reimbursed unsubstantiated travel expenses incurred by Pastor B’s son D

The IRS began its analysis by noting that intermediate sanctions under section 4958 only can be assessed against “disqualified persons,” and that the regulations 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. Since Pastor B met the definition of a disqualified person, so did the members of his family including his sons. As a result, the IRS could assess intermediate sanctions against his family members for any excess benefit paid by the church.

The IRS defined an excess benefit transaction (resulting in intermediate sanctions) as follows:

An excess benefit transaction is a transaction in which an economic benefit is provided by a tax-exempt organization, directly or indirectly, to or for the use of any disqualified person and the value of the economic benefit provided by the organization exceeds the value of the services received for providing such benefit.

Reimbursements of an employee’s expenses by the exempt organization are disregarded for purposes of section 4958 if the reimbursements satisfy all of the requirements of [an accountable reimbursement plan] ….

Expenditures of organization funds by an employee that satisfy the [business deduction] requirements under sections 162 and 274, including the substantiation requirements of those provisions and the regulations thereunder, do not constitute excess benefits under section 4958.

Any reimbursement of expenses by the organizations to an employee, or direct expenditures of organization funds by the employee, are automatic excess benefits to the extent that they do not satisfy the requirements of [an accountable reimbursement plan] or sections 162 and 274 of the tax code and the regulations thereunder, unless they are substantiated as compensation ….

In this case, Pastor B and his son expended church funds, and used church assets, in a variety of ways described below …. The son does not contend that these expenditures and uses were intended as compensation to himself or his relatives. In any event, there is no evidence in the record that would satisfy the contemporaneous substantiation rules of the regulations.

It follows that unless the son can satisfy the accountable plan requirements or the requirements of sections 162 and (to the extent relevant) 274 and the regulations thereunder for ordinary and necessary business expenses, the expenditures and use of church funds described below must be treated as automatic excess benefits.

The IRS analysis of each transaction is summarized below.

(1) use of church credit cards by Pastor B’s son D

Pastor B’s son D used a church credit card for gasoline purchases. The church insisted that its policy regarding personal use of any church credit cards is that credit cards are to be used only for church business and not for any personal use. In the event of any personal use, the person utilizing the card would be obligated to reimburse church 100%.

The IRS noted, “The church retained its credit card statements and a few receipts. it did not note any business purpose or relationship with respect to the entries on such statements. It did not maintain any records, account books, diaries, etc., to establish the business purpose or relationship of such expenditures.” The IRS concluded:

[The tax code] provides that expenses must be ordinary and necessary to be a business deduction. The expenses must be contemporaneously documented with time, place, business purpose, and business relationship. The church maintained credit card statements and a few receipts. However, neither the church nor Pastor B’s son documented the business purpose or relationship of his expenditures. It does not appear that the son kept any account books, diary, or other records demonstrating that the charges he made on the church credit cards were for business purposes.

As a result, the IRS determined that the church’s reimbursements of the son’s credit card charges were “nonaccountable,” and, since neither the church nor the son reported these reimbursements as taxable income they constituted “automatic” excess benefits resulting in intermediate sanctions in the amount of 25% of the amount of the excess benefits, plus an additional 200% of the amount of the excess benefits if the excess benefit transactions were not corrected within the taxable period (defined above).

While the son was personally liable for these intermediate sanctions, so was his father. The IRS observed,

We note that Pastor B was founder, president, and chief executive of the church. As a practical matter, he had total control of all the church’s expenditures. He either approved of the excess benefit transactions by his son or he acquiesced in them. If Pastor B had withdrawn funds from the church and given them to his family members, there would have been no question that such gifts would be taxable excess benefits to him. By authorizing or allowing his son and other relatives, the natural objects of his bounty, to make unlimited expenditures of church funds for personal purposes, without any substantiation or evidence of a business purpose, he in effect improperly removed charitable assets from the church and gave them to his relatives. Accordingly, he not only is liable for the excess benefit transactions from which he personally benefited, but also is jointly and severally liable for all the excess benefits [paid to his son and other members of his family].

(2) church reimbursement of cell phone expenses incurred by Pastor B’s son D

The church provided Pastor B’s son D with a cell phone and paid most if not all of the charges associated with this phone. The church insisted that its policy regarding personal use of cell phones was that personal telephone calls should not be charged to any church paid phone, and that any personal calls should be reimbursed 100% to the church.

The church provided the IRS with “voluminous records listing calls from the church’s cellular phones.” However, the documents “list only the telephone numbers, and do not indicate with whom the son spoke and the business reasons for their conversation. Aside from phone calls made to church phones that would most likely be church business, all other calls were not substantiated as required.”

As a result, the IRS determined that the church’s reimbursements of the son’s cell phone charges were “nonaccountable,” and, since neither the church nor the son reported these reimbursements as taxable income they constituted “automatic” excess benefits resulting in intermediate sanctions in the amount of 25% of the amount of the excess benefits, plus an additional 200% of the amount of the excess benefits if the excess benefit transactions were not corrected within the taxable period (defined above).

The IRS found Pastor B and his son “jointly and severally liable” for the intermediate sanctions, meaning that the IRS could collect the excise taxes from either of them.

(3) the church reimbursed unsubstantiated travel expenses incurred by Pastor B’s son D

The church reimbursed the travel expenses of Pastor B’s son in connection with a seminar. The IRS concluded that the son had failed to substantiate that the trip was for business purposes. As a result, the church’s reimbursement of the son’s travel expenses was “nonaccountable,” and, since neither the church nor the son reported the reimbursement as taxable income it constituted an “automatic” excess benefit resulting in intermediate sanctions in the amount of 25% of the amount of the excess benefit, plus an additional 200% of the amount of the excess benefit if the transaction was not corrected within the taxable period (defined above).

The IRS found Pastor B and his son “jointly and severally liable” for the intermediate sanctions, meaning that the IRS could collect the excise taxes from either of them.

Ruling #2: IRS Letter Ruling 200435020

This ruling involved the same church and pastor as Ruling #1 (summarized above). However, the transactions involved in this ruling were as follows:

(1) use of church credit cards by Pastor B

(2) church reimbursement of cell phone expenses incurred by Pastor B

(3) personal use of church-owned vehicle

(4) “second home” home expenses paid by the church

(5) home expenses of Pastor B’s son paid by the church

(6) home expenses on Pastor B’s primary residence paid by the church

(7) payment of miscellaneous personal expenses on behalf of Pastor B

The IRS applied the same definition of an excess benefit transaction (resulting in intermediate sanctions) that it used in Ruling #1.

The IRS analysis of each transaction is summarized below.

(1) use of church credit cards by Pastor B

The church provided Pastor B with five credit cards which he used to purchase meals, gasoline, department store items, car repairs, groceries, hotel charges, and clothing. The church claimed that its policy regarding church credit cards was that they were to be used only for church business and not for any personal use. In the event of any personal use, the person utilizing the card would be obligated to reimburse the church 100%.

The IRS noted, “The church retained its credit card statements and a few receipts. It did not note any business purpose or relationship with respect to entries on such statements. It did not maintain any records, account books, diary, etc. to establish the business purpose or relationship of such expenditures.” The IRS concluded,

The tax code provides that expenses must be ordinary and necessary to be a business deduction. The expenses must be contemporaneously documented with time, place, business purpose, and business relationship. The church maintained its credit card statements and a few receipts. However, neither the church nor Pastor B documented the business purposes of these expenditures. It does not appear that Pastor B kept any account books, diaries, or other records demonstrating that the charges the family made on church credit cards were for business purposes.

As a result, the IRS determined that the church’s reimbursements of Pastor B’s credit card charges were “nonaccountable,” and, since neither the church nor Pastor B reported these reimbursements as taxable income they constituted “automatic” excess benefits resulting in intermediate sanctions in the amount of 25% of the amount of the excess benefits, plus an additional 200% of the amount of the excess benefits if the excess benefit transactions were not corrected within the taxable period (defined above).

(2) church reimbursement of cell phone expenses incurred by Pastor B

The church provided Pastor B with a cell phone and paid expenses associated with this phone. The IRS noted that cell phones are “listed property” under section 280F of the tax code, meaning that “strict substantiation requirements must be in place, otherwise the use of the cell phones is taxable to the employee.” However, it concluded that the amount of expenses paid by the church were so low that they qualified as a nontaxable “de minimis” fringe benefit. A de minimis fringe benefit is one that is so minimal in value that it would be “unreasonable or administratively impractical” to account for it.

(3) personal use of church-owned vehicles

The church purchased a car that was parked in Pastor B’s garage. Pastor B and his wife were the only persons who had access to the car. The church claimed that its policy regarding personal use of any vehicles it owned was that vehicles “are to be used only for business and not for any personal use. In the event of any personal use, any person utilizing the vehicle would be obligated to reimburse the church at the current IRS approved rate per mile.” The church also declared, “There are no employee expense accounts or reimbursements other than described herein. All employees and ministers have their own vehicles for their personal use and consequently have little or no reason to drive a church-owned vehicle for personal use. All vehicles owned by the church are to be used for business exclusively.”

The IRS concluded, “The car is kept at Pastor B’s personal residence, and he and his wife are the only people with access to it. Pastor B argued that he drove this car occasionally, and only on business. However, use of a vehicle is treated as personal use unless a taxpayer substantiates business use.” As a result, the IRS determined that Pastor B’s exclusive access to the church-owned car constituted personal use of church property, and since no taxable income was reported during the year in question by either the church or Pastor B, the annual rental value of the car constituted an “automatic” excess benefit resulting in intermediate sanctions in the amount of 25% of the amount of the excess benefit, plus an additional 200% of the amount of the excess benefit if the excess benefit transaction was not corrected within the taxable period (defined above).

(4) “second home” expenses paid by the church

The church purchased a home that was used exclusively by Pastor B and his wife (in addition to their principal residence). The IRS noted that the church paid for several expenses associated with the home, including furnishings, utilities, security system, cable TV and landscaping. The IRS determined that no business purpose had been proven for any of these expenses, and therefore church assets had been used for personal purposes without having been reported as taxable income by the church or Pastor B in the year the benefits were provided. Therefore, they constituted “automatic” excess benefits resulting in intermediate sanctions in the amount of 25% of the amount of the excess benefit, plus an additional 200% of the amount of the excess benefit if the excess benefit transaction was not corrected within the taxable period (defined above).

Key point. The IRS provided some indication of how it will determine a home’s “fair rental value.” This is an important point, since this value must be known in determining the nontaxable portion of a church-designated housing allowance for ministers who own their home. The IRS observed, “In the agent’s report, she determined an annual amount of $X as rental value for the property …. She stated: ‘Calling a property management company and asking about the house determined this rental value. I did not identify the address; rather I used the information about the house, how many acres, square footage and area, etc. The rental value was $X per month. This appears correct as the other houses owned and operated by Pastor B and the church were consistent with this value. The other rentals were not as spacious, nor did they have the amenities consistent with this property. In addition, the other rentals were in [an adjacent county] as opposed to [this county], which has a higher rental value. Those houses were being rented for approximately $Y/month.”

(5) home expenses of Pastor B’s son paid by the church

The church purchased a home that was occupied by Pastor B’s son for six months. The son did not pay rent, and he and his parents were the only persons having access to the home. After the son moved out of the home, his parents gave the church a check for the purpose of belatedly paying rent for their son’s occupation of the home. The church paid monthly utility, landscaping, and cable TV expenses at the house. It also paid a monthly fee for a home security system.

The IRS determined that no business purpose had been proven for any of these expenses, and therefore church assets had been used for personal purposes without having been reported as taxable income by the church, Pastor B, or Pastor B’s son in the year the benefits were provided. Therefore, they constituted “automatic” excess benefits resulting in intermediate sanctions in the amount of 25% of the amount of the excess benefit, plus an additional 200% of the amount of the excess benefit if the excess benefit transaction was not corrected within the taxable period (defined above).

(6) home expenses on Pastor B’s primary residence paid by the church

The church paid for landscaping, cable TV, and a security alarm system for Pastor B’s primary residence. The IRS determined that no business purpose had been proven for any of these expenses, and therefore church assets had been used for personal purposes without having been reported as taxable income by the church or Pastor B in the year the benefits were provided. Therefore, they constituted “automatic” excess benefits resulting in intermediate sanctions in the amount of 25% of the amount of the excess benefit, plus an additional 200% of the amount of the excess benefit if the excess benefit transaction was not corrected within the taxable period (defined above).

Key point. These items were all legitimate housing expenses that were nontaxable for income tax reporting purposes because of the housing allowance, and as a result there was no need for the church or Pastor B to have reported them as taxable income.

(7) payment of miscellaneous personal expenses on behalf of Pastor B

The church paid an investigator to conduct surveillance activities on Pastor B’s daughter-in-law, and attorney’s fees for services rendered in connection with a personal dispute. The IRS determined that no business purpose had been proven for any of these expenses, and therefore church assets had been used for personal purposes without being reported as taxable income by the church or Pastor B in the year the benefits were provided. Therefore, they constituted “automatic” excess benefits resulting in intermediate sanctions in the amount of 25% of the amount of the excess benefit, plus an additional 200% of the amount of the excess benefit if the excess benefit transaction was not corrected within the taxable period (defined above).

The IRS concluded this ruling with the following observation:

We note that Pastor B was founder, president, and chief executive of the church. As a practical matter, he had total control of all church expenditures. He either approved of the excess benefit transactions by his son or he acquiesced in them. If he had withdrawn funds from the church and given them to his family members, there would have been no question that such gifts would be taxable excess benefits to him. By authorizing or allowing his son and other relatives, the natural objects of his bounty, to make unlimited expenditures of church funds for personal purposes, without any substantiation or evidence of a business purpose, he in effect improperly removed charitable assets from the church and gave them to his relatives. Accordingly, he not only is liable for the excess benefit transactions from which he personally benefited, but also is jointly and severally liable for all the excess benefits [provided to members of his family].

Ruling #3: IRS Letter Ruling 200435021

This ruling involved the same church and pastor as Ruling #1 (summarized above). The transactions were identical to those described in Ruling #2, except that the IRS focused on Pastor B’s wife. Since she was a “family member” of Pastor B, she was a “disqualified person” subject to intermediate sanctions. Further, Pastor B was jointly and severally liable for her penalties.


Ruling #4: IRS Letter Ruling 200435022

This ruling involved the same church and pastor as Ruling #1 (summarized above). However, the transactions involved in this ruling were as follows:

(1) use of church credit cards by Pastor B’s son C

(2) church reimbursement of cell phone expenses incurred by Pastor B’s son C

(3) the church’s purchase of a computer from Pastor B’s son C

The IRS applied the same definition of an excess benefit transaction (resulting in intermediate sanctions) that it used in Ruling #1.

The IRS analysis of each transaction is summarized below.

(1) use of church credit cards by Pastor B’s son C

Pastor B’s son C used a church credit card for gasoline purchases. The church insisted that its policy regarding personal use of any church credit cards is that credit cards are to be used only for church business and not for any personal use. In the event of any personal use, the person utilizing the card would be obligated to reimburse church 100%.

The IRS noted, “The church retained its credit card statements and a few receipts. It did not note any business purpose or relationship with respect to the entries on such statements. It did not maintain any records, account books, diaries, etc., to establish the business purpose or relationship of such expenditures.” The IRS concluded:

[The tax code] provides that expenses must be ordinary and necessary to be a business deduction. The expenses must be contemporaneously documented with time, place, business purpose, and business relationship. The church maintained credit card statements and a few receipts. However, neither the church nor Pastor B’s son documented the business purpose or relationship of his expenditures. It does not appear that the son kept any account books, diary, or other records demonstrating that the charges he made on the church credit cards were for business purposes.

As a result, the IRS determined that the church’s reimbursements of the son’s credit card charges were “nonaccountable,” and, since neither the church nor the son reported these reimbursements as taxable income they constituted “automatic” excess benefits resulting in intermediate sanctions in the amount of 25% of the amount of the excess benefits, plus an additional 200% of the amount of the excess benefits if the excess benefit transactions were not corrected within the taxable period (defined above).

While the son was personally liable for these intermediate sanctions, so was his father. The IRS observed,

We note that Pastor B was founder, president, and chief executive of the church. As a practical matter, he had total control of all the church’s expenditures. He either approved of the excess benefit transactions by his son or he acquiesced in them. If Pastor B had withdrawn funds from the church and given them to his family members, there would have been no question that such gifts would be taxable excess benefits to him. By authorizing or allowing his son and other relatives, the natural objects of his bounty, to make unlimited expenditures of church funds for personal purposes, without any substantiation or evidence of a business purpose, he in effect improperly removed charitable assets from the church and gave them to his relatives. Accordingly, he not only is liable for the excess benefit transactions from which he personally benefited, but also is jointly and severally liable for all the excess benefits [paid to his son and other members of his family].

(2) church reimbursement of cell phone expenses incurred by Pastor B’s son C

The church provided Pastor B’s son C with a cell phone and paid most if not all of the charges associated with this phone. The church insisted that its policy regarding personal use of cell phones was that personal telephone calls should not be charged to any church paid phone, and that any personal calls should be reimbursed 100% to the church.

The church provided the IRS with “voluminous records listing calls from the church’s cellular phones.” However, the documents “list only the telephone numbers, and do not indicate with whom the son spoke and the business reasons for their conversation. Aside from phone calls made to church phones that would most likely be church business, all other calls were not substantiated as required.”

As a result, the IRS determined that the church’s reimbursements of the son’s cell phone charges were “nonaccountable,” and, since neither the church nor the son reported these reimbursements as taxable income they constituted “automatic” excess benefits resulting in intermediate sanctions in the amount of 25% of the amount of the excess benefits, plus an additional 200% of the amount of the excess benefits if the excess benefit transactions were not corrected within the taxable period (defined above).

The IRS found Pastor B and his son “jointly and severally liable” for the intermediate sanctions, meaning that the IRS could collect the excise taxes from either of them.

(3) the church’s purchase of a computer from Pastor B’s son C

The church purchased a computer from Pastor B’s son C. The IRS concluded that “there has been no evidence provided to substantiate that the church’s purchase of a computer from C should be categorized as an arm’s length transaction. Although counsel has argued that it was, and that the church benefited from the computer’s capabilities, counsel has failed to provide any supporting documentation assessing the value and condition of the computer at the time it was sold. Accordingly, the sale of the computer constituted an excess benefit transaction attributable to C.”

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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