When Two Churches Become One

The legal ins and outs of church mergers, acquisitions, and donations/dissolutions.

As economic pressures build, churches of various sizes and types are considering whether their church can—or should—merge with another church, acquire another church, or dissolve their church and donate the assets to another church (collectively referred to herein as “transactions”).

These transactions have long been common in the business world, but interest in them has grown rapidly recently within the nonprofit sector. The very phrase “mergers and acquisitions” or the concept of these types of transactions can evoke many different images.

Some may envision a hostile corporate takeover. Others may picture a fluid joining of two distinct bodies of believers and, as a result, becoming one church community. Still others may think of a resource-rich church with declining membership partnering with a vibrant church with few financial resources.

While there are resources to help leaders evaluate the decision whether or not to merge, acquire, or dissolve, there is little guidance as to how to legally effectuate the transaction options available to churches.

Due diligence

Before we begin discussing the options for these transactions in detail, it is important to take a step back and make sure the proper due diligence has been exercised before a church entertains one of these transactions.

The overall goal of due diligence is to make sure that there has been sufficient inquiry and collection of information about the future church partner, surviving church, or dissolving church to enable your church to make an informed decision about what its next step should be. It is important that all parties have reviewed the legal and financial situation of the other church before formally committing to one of these transactions.

Types of information that should be investigated during the due diligence period includes, but is certainly not limited to: governing documents (articles of incorporation, bylaws, amendments of the same); contracts; personnel policies and structure; agreements with vendors and other organizations; real estate records; marketing materials; programs; activities; IRS records; financial statements; audited financial reports; licenses; potential or current litigation issues; details about debts or other liabilities owed; and so on.

The due diligence process requires the churches to work together in gathering and analyzing all the information. So although the due diligence process is incredibly important to the overall success of the transaction, it is also a good indicator of how well the churches will work together throughout the entire transaction.

10 keys to successful transactions

Several principles can make a merger or acquisition successful. Outlined below are 10 important principles, but church leaders should work with their church and legal counsel to develop a list of what would make the merger or acquisition successful.

1. Keep Jesus Christ front and center.

He should be the primary motivation for the merging or acquiring of another church. During the process, remember that everything should be done as unto Christ and to honor His bride, the church. Ephesians 5:22-23 compares the union of husband and wife to that of Christ and the church. The imagery and symbolism of marriage is often applied to Christ and the body of believers known as the church.

Marriage is also a good way to describe the process of two church bodies merging together. It is important to remember to always go into negotiations or discussion with the mindset that the goal is for the new church community to be able to experience Jesus Christ on a deeper level. The goal of the discussions and negotiations should not be to “win” in the process or make the other team “lose”; it should all be done for the glory of God. In doing so, all the participants to the merger or acquisition will be exemplifications of a “win-win” outcome for all concerned and unto the body of Christ.

2. Verify the motivations for the merger or acquisition.

Political pressure within the church, tough economic times, real property issues, and structural issues may not be the best motivations for a merger or acquisition. A positive motivation for a merger or acquisition means it is more likely to succeed.

3. Compare purposes and values.

Make sure the churches have the same values and beliefs. If these core principles are too far apart, then there could be an issue down the road. Understand it’s a marathon, not a short sprint. Be prepared to have some really great times and some tough times throughout the process. Be patient. Let the process, negotiations, and discussions naturally happen.

If the churches try to rush anything, then there is a strong likelihood that people will get frustrated easily, forget the reason for the deal in the first place, and potentially quit. Mistakes are generally made when parties try to race through negotiations or transactions, which can lead to big problems later. So be patient and try to focus on the mission of the transaction, not how quickly it can be accomplished.

4. Give each church time to discuss and present their expectations.

Allowing everyone to voice their expectations at the very beginning of discussions will enable each church to openly discuss expectations and allow each church to work together to make sure most of the expectations are met. Churches can get frustrated if they have a certain expectation coming into the transaction and the expectation is not met, so it is best if both churches make their expectations known up front.

5. Wisely choose your leader.

The leader during the discussions and negotiations of the transaction will set the tone for how each church’s staff and members respond to the upcoming changes. It is important to make sure that the leader is not necessarily someone who is highly compensated or has the most power. A leader is someone who is respected by all of the participants; someone who is called, personable, sees the vision, stays actively involved, and is equipped to lead the church.

6. Do your homework.

Ask any for-profit company what the most important task is in getting ready to sell or buy a business and the task would probably be due diligence. Although it is discussed above, it bears repeating: Just as due diligence is vital to any for-profit company merging or acquiring another for-profit entity, it is also true for nonprofits because they have liabilities, assets, creditors, leases, contracts, and agreements just like any for-profit company has. Therefore, it is very important that churches conduct due diligence in determining what the other church looks like at its core, underneath the ministries and programs that it conducts on a daily basis.

7. Discuss the ideal “final picture” of the transaction.

What will things look like after the deal is completed? If a merger takes place, the churches should discuss what internal programs, ministries, and outreach programs the surviving church will continue to operate and support. The churches also must consider which employees will be employed with the surviving church. If an acquisition takes place, the purchasing church should decide whether it wants to continue any of the dissolving church’s programs or ministries and whether it wants to keep any of the dissolving church’s leaders.

8. Understand why others failed.

Do this by looking at other churches who have successfully (and unsuccessfully) undertaken the same type of transaction that your church might pursue. It is important for each church to understand what has (and has not) worked for others in the past, so that they can learn from the failures and successes of those transactions.

9. Glorify God.

Remember that whatever the leaders of the church do, however each church behaves during negotiation, and whatever the end result of the transaction is, it should all be done for the glory of God.

10. Understand, it’s a marathon, not a short sprint.

Be prepared to have some really great times and some tough times throughout the process. Be patient. Let the process, negotiations, and discussions naturally happen. If the churches try to rush anything, then there is a strong likelihood that people will get frustrated easily, forget the reason for the deal in the first place, and potentially quit. Mistakes are generally made when parties try to race through negotiations or transactions, which can lead to big problems later. So be patient and try to focus on the mission of the transaction, not how quickly it can be accomplished.

Mergers

What is a merger?

As a preliminary matter, it is important for a church to determine what a merger of two formerly distinct entities is. A merger is a formal legal process in which one of the pre-existing entities completely becomes a part of, or merges, with the second entity. The combined entity that remains after the merger is known as the “surviving entity,” having completely absorbed the other “merging entity.” Following the merger, the surviving entity assumes all liabilities of the merging entity, and continues to transact business as a unified whole moving forward in its daily operations.

There are many complex matters to attend to during a formal merger. It is important that entities considering a merger not rush into the process and devote a great deal of time, prayer, and wise counsel in deciding whether a merger is something that should be explored. A merger will involve the consolidation of at least two, and sometimes more, formerly separate and distinct entities.

Each may have very different cultures and operating procedures. It is crucial that churches considering a merger focus on what the merging entities have in common, and commit to working together in common purpose to develop shared values, vision, goals, and culture during the merger process.

Generally speaking, it is helpful to look at a merger of two entities as analogous to a marriage relationship between two individuals. Like in a marriage, a merger is a complete combination, without reservation, of two formerly separate and distinct entities. The parties involved are not able to pick and choose from only the best parts of each party to merge. In a merger, entities combine the good, the bad, the ugly, and even the unknown.

So, it is crucial that churches considering the merger process devote a significant amount of time, prayer, and analysis to the decision to merge. If it is determined at a later date that a merger was entered into too hastily, or the parties decide to separate at a later date, much like a divorce, the costs of separating can be extremely burdensome, not only spiritually, but also financially.

When should we consider a merger?

If you are faced with a decision to combine two entities, it is important to determine when it is appropriate to consider a merger. There are many reasons why churches consider mergers. Mergers are often considered for economic reasons, changing community dynamics, property and facility concerns, a denominational mandate, or even a church plant that did not succeed as planned, among other reasons.

It is also important to note that mergers are usually not the preferred transaction for combining entities for several reasons. The primary concern is that a merger entails the complete assumption of all liabilities, including unknown liabilities, by the surviving entity. However, there are some circumstances in which a formal merger may be the only option.

An example of this scenario would be when there are known liabilities that cannot be dismissed or ignored, such as existing loans or pending lawsuits, which make an asset purchase alone impossible or inadvisable. As such, it may be helpful to consider a merger as an option of last resort if the other options discussed in this article are not available.

How do we accomplish a merger?

If the decision to merge is made, it may be helpful to break the merger process down into a series of steps, which are as follows:

Plan of merger. In this first step, initial discussions between church leadership of the merging entities will take place. Once the entities informally decide to embark upon this process, one of the parties will prepare a plan of merger, likely drafted by an attorney. This plan of merger will be presented to the church boards and possibly shared with church leadership or the congregations to determine if a merger is something that all parties involved would have interest in. Many questions will likely be asked and answered during this stage, which requires coordination and patience so that everyone involved can become comfortable with the thought of merging.

Board resolution. If it is determined that a merger is something that all parties would like to explore further, a resolution of each church board will be drafted, again likely by an attorney, for approval. Depending on the structure of your church, it may also be necessary to obtain approval from any denominational authority during this stage, however this is not always required. If the boards of both churches approve the resolutions, then the formal process of merging can begin.

Articles of merger. The main component of a church merger is the drafting and filing of articles of merger with the secretary of state. Articles of merger typically include the plan of merger or identify the location and accessibility of the plan of merger. Such articles also generally consist of a statement identifying the entities to be merged as well as the surviving entity. In addition, the articles require statements confirming that the merger has been approved by appropriate authorities within the merging entities, the effective date of the merger, and other statements and disclosures required under state law. It is important to note that the laws of each state will control what specific information must be included in the articles of merger, so it is advisable to consult an attorney regarding the specific required components for the state in which your church is incorporated.

Notification and dissemination of the articles of merger. Once the articles of merger have been drafted, they will need to be considered and approved by the governing body of the church. In some churches, this is the board of directors. Other churches require a congregational vote. To determine who has authority to make this decision, the joining church will need to carefully review its corporate documents. Proper notice must be provided to either the board or the voting members of the church, if any, regarding the contents of the articles of merger and the scheduled meeting to vote on such articles. A meeting will then need to be held so that the articles of merger may be voted on and potentially approved.

Meeting, voting, and filing. If the merger requires a congregational vote, at the noticed meeting, church leadership will answer any questions voting members may have regarding the merger and proposed articles of merger. A vote will then be held to determine whether or not the articles of merger will be approved by the church. If the governing body of the church is the board of directors, the board shall convene at a duly held meeting and carefully consider the proposed merger prior to voting on the issue. Once the merger has been approved by the proper governing body, the final formal step in the merger process will be to file the approved articles of merger with the secretary of state. Once the articles are filed, the merger will either be complete and effective or may not become effective until the receipt of a certificate of merger from the secretary of state.

What are the pros and cons of a merger?

As with any transaction, there are positive and negative aspects to a merger. The primary positive aspect of a merger is that it is usually available as an option to merge two churches where there are known liabilities that cannot be dismissed or ignored. It may be helpful to look at mergers as a fallback position that will still be available in most circumstances if other more attractive options are not.

Another positive feature of a merger is that a church that is facing difficulty or the possibility of having to close its doors will essentially be allowed to continue its ministry in some form or fashion. This may be preferable to an alternative, such as filing for bankruptcy protection or simply ceasing operations altogether. Also, when two entities merge, the community in which they are located does not lose a church. In some circumstances, a merger can result in the creation of a stronger and more stable ministry moving forward.

However, there are downsides to mergers as well that must be carefully considered. As mentioned above, surviving entities will take on all liabilities of the merging entity, even those that are unknown at the time of merger. It is crucial for churches to perform solid and extensive due diligence before contemplating a merger. Even after the most diligent and thorough due diligence possible, though, the surviving church could still encounter previously unknown liabilities once the merger has been completed.

Also, due to the complete absorption of the merging entity into the surviving entity, mergers take more time to complete, and potentially require coordination with other outside parties, such as lenders. Because of the complexity involved and the risk of outside involvement, mergers are also more expensive to complete than other transactions. Finally, because of the likely reorganization and possible replacement of senior staff, the congregation of the absorbed church will often have to become accustomed to new leadership within the surviving entity.

In conclusion, a merger of formerly distinct entities can be an option for many churches. However, the formal merger process can be complex, time consuming, and can involve hidden pitfalls that the surviving entity should anticipate before committing to a merger. These issues must be anticipated and addressed not only before and during the merger process, but oftentimes well after the merger, as the merged entities become accustomed to the new structure in which they are now operating.

As such, it will be important for churches considering a merger to retain legal counsel to guide them through the process so that ultimately, the surviving entity can emerge from the process as a healthy and united whole, and hopefully stronger than it had been as separate entities.

Asset purchase and dissolution

What is an asset purchase and dissolution?

The second option available to churches is to enter into an asset purchase agreement wherein the healthy lead church buys the assets of the joining church. An asset purchase transaction is a contractual agreement that allows the lead church to acquire either all or a selection of the joining assets and liabilities. The written agreements in such a transaction define the assets (and the liabilities, if necessary and/or agreed to) to be sold. In such an arrangement, the lead church would be purchasing whatever the two parties define as “the church” of the dying organization. Because certain assets and/or liabilities can be excluded from the transaction, asset purchase agreements are widely used contracts.

By purchasing the assets of the joining church, the lead church can help to provide the joining church with enough cash funding so that the joining church can pay some or all of its existing liabilities such that the joining church can then completely wind down and dissolve. Assets can be nearly anything: buildings, real estate, hymnals, office supplies, nursery equipment, intellectual property, sound equipment, vehicles, and so on.

Liabilities often attach themselves to the assets and travel with them; so, for example, if the joining church has an outstanding loan on its facilities, the loan would either need to be paid in full or would need to travel with the building in the asset purchase agreement. Depending on the circumstances, the joining church may need to notify its creditors of the impending transaction. For example, if the joining church is currently engaged in a commercial lease agreement, the joining church will need to notify its landlord that it will be dissolving and likely breaking the lease agreement earlier than contracted. The landlord may or may not agree to assign the lease to the lead church (assuming, of course, that the lead church wants to maintain the lease).

Asset purchase agreements are fairly simple in nature, though the paperwork can seem complex. Since the primary goal of having a purchase asset agreement is to formally set out the exact arrangement as agreed to by the two churches, the agreement will need to specifically set out certain provisions. A church looking to enter into such an arrangement should absolutely seek advice and assistance from an attorney who can ensure that both parties have completed their respective due diligence requirements, as well as to make sure that the written agreement is in line with state laws and practices.

The written agreement will need to contain provisions that may seem obvious to the involved parties, but—from a legal standpoint—are important to set out in a formal written agreement. For example, at a minimum the agreement should set out:

  • the parties involved in the transaction;
  • the compensation that will be made for the assets;
  • the effective date, or when the agreement will become effective;
  • the closing date, if different than the effective date;
  • which assets are being acquired; the liabilities that will be attached, if any;
  • that the joining church has the authority to sell its assets;
  • that the assets are of a value equal to the purchase price;
  • that the joining church has no known or unknown liabilities (including legal or financial liabilities) that are not already articulated in the agreement;
  • and any other provisions attached to the assets at the time of transfer.

In addition, the formal written agreement should state that the lead church has the authority and ability to buy the assets.

Following the completion of the sale, the joining church should ideally be a mere shell of its former self, existing only long enough to disperse with any remaining liabilities and to complete and file the appropriate dissolution paperwork with the state in which the joining church is incorporated.

When should a church use this option?

Many churches are reluctant, if not completely opposed, to the idea of an “asset purchase agreement.” This reluctance is usually traced to the leaders of either the lead church or the joining church and their general avoidance of any actions that sound too “corporate” in nature. It is true that someone searching the term “asset purchase” online will find results for deals involving banks and oil companies. However, churches really should feel free to view these transactions in a more positive light.

The widespread use of asset purchase agreements in the for-profit world means that these transactions have been tested and well received. In certain situations, particularly when there is some outstanding debt/liability that must be addressed before the joining church can be dissolved (and especially in situations when the joining church just does not have the resources to disperse of these debts/liabilities by their own means), the sale and purchase of the assets of the joining church may certainly be the best and easiest option for both parties. Moreover, from a public relations perspective, many congregation members will understand and approve of such transactions as they may already be familiar with them from their own business experience.

Lastly, it is important that the joining church takes the extra steps to formally dissolve following the closing and transfer of assets to the lead church. For liability purposes, it is generally not advisable to leave an empty corporate shell in existence. In addition, the individual persons who served as the officers, directors, and employees of the joining church will often have moved on in their personal lives and will no longer want their names tied to an organization that is no longer functioning but which, because it is still in existence, could technically be sued.

What are the pros and cons of an asset purchase and dissolution?

As with each of the transactions described in this article, there are both positive and negative aspects to asset purchase agreements that must be weighed by the leaders of both the lead church and joining church prior to entering into such a formal written agreement. In the case of an asset purchase, most tend to be positives for both parties.

On the positive side for the joining church, asset purchase agreements allow it to receive some cash income that it can use to pay off any outstanding liabilities. No church wants to cease to exist without making good on the debts the organization took on in better financial times. Even more, no church wants to leave its former directors, officers, or employees personally on the hook for outstanding debts of the organization, which could be an issue if anyone signed off as a personal guarantee of the organization (something which is often required in order to enter into a commercial lease agreement, and so on). An asset purchase agreement would instead provide the joining church with the benefit of having cash reserves to pay its outstanding liabilities in total, or at least the ability to possibly settle for a lower payoff amount with the debt holder.

The main advantage for the lead church is that it can set the specific terms that the joining church must abide by or agree to in order for the transaction to take place. Generally, most joining churches are looking to enter into such an arrangement because they have fallen on hard times and cannot continue (usually from a financial perspective) to continue their ministry. However, a lead church should proceed with caution when entering into an asset purchase. An asset purchase agreement allows the lead church to proceed with caution by setting its own terms by which it will legally effectuate the joining of the two organizations. This allows for a considerable amount of control on the part of the lead church.

In addition, an asset purchase allows the lead church to merely purchase and assume known assets and liabilities. Whereas a merger leaves the lead church with both known and unknown risks, an asset purchase agreement only gives the lead church what it has paid for and agreed to in writing. For most churches, this option will be a better fit as compared to a merger. Simply speaking, most lead churches will not want to absorb the liabilities of the joining church.

Possibly the only downside to an asset purchase transaction for the lead church is that the lead church must come up with whatever cash amount is agreed to in exchange for the assets of the joining church. As opposed to the third option below, a donation of assets rather than a purchase of assets, the joining church has to actually expend resources in order to obtain the parts of the joining church that it wants. This could cause the lead church to need to take out a loan or pull together resources originally intended for other ministry activities.

Donation/Dissolution

What is a donation/dissolution?

This particular section explores how two churches can join forces through a transaction where a church donates its assets to another church and then dissolves (“donation/dissolution”).

In this scenario, a church determines that it wants to combine with another church. After the church (the “joining church”) identifies and pays off any outstanding debts, it then donates all remaining assets to another tax-exempt, nonprofit organization (the “lead church”). The joining church then formally dissolves by filing the appropriate dissolution information in the state where the church was incorporated. By filing the dissolution information, the joining church will end its corporate existence.

A donation/dissolution is likely the cleanest, most straightforward, and quickest methods of combining two organizations. Because only assets are transferred, the lead church does not face known or unknown liabilities of the joining church being imputed to the lead church. This is of particular comfort to lead churches who will not have to face the unpleasant situation of finding out that the joining church has, for example, had sexual abuse claims filed against it or has previously filed for bankruptcy. Because only assets are transferred, the lead church will not have to fear the risk of absorbing liabilities of the joining church.

When can a donation/dissolution be used?

This particular transaction of combining churches is a great option to consider because it is appropriate in a wide variety of situations—even when the motivation for the combination of churches differs. For instance, a donation/dissolution is appropriate where one church has decreasing attendance, struggling finances, and desires to be absorbed by a healthier, more vibrant church community. It is also appropriate in circumstances where a larger church is seeking to establish another satellite campus and a church in the desired location wants to become the actual satellite campus.

Even though this option is highly versatile and is appropriate in a variety of circumstances, use of the donation/dissolution should not be used in situations where the joining church has substantial debt that it is unable to pay off prior to dissolving. For example, a church will not be permitted to dissolve if it has an outstanding mortgage or judgment from a lawsuit. Rather, the donation/dissolution should only be used in situations where the joining church either has no existing debt or it has the ability to pay all debts prior to dissolution.

The reason for this limitation can sometimes be found in the church’s dissolution clause. This clause is a key component of corporate documents for most organizations and it is critical to an organization’s operation as a tax-exempt organization. If an organization’s corporate documents do not contain a dissolution clause, state law will likely impose it. Essentially, the dissolution clause requires that, upon dissolving, a tax-exempt organization must distribute its assets to another tax-exempt organization. Most dissolution clauses require that all liabilities be paid prior to distributing remaining assets to another tax-exempt organization.

In today’s economic conditions, the likelihood of finding a church with no debt is probably small, especially when many of the churches seeking to combine with other churches may be doing so because of financial stress they may be experiencing. Despite this limitation, it is not impossible for churches that have debt to utilize the donation/dissolution method so long as the church pays off all debt prior to dissolving.

For example, if the joining church has a large mortgage on its building, the church would not be eligible for dissolution unless it first paid off its mortgage. If a church’s debt is large and the likelihood that the church could pay it off prior to dissolution is minimal, then the church should consider a different option of combining entities, such as a merger.

How do we accomplish a donation/dissolution?

If you are considering using the donation/dissolution method to combine with another church, you will need to be prepared to walk through the following steps to effectuate the transfer of assets and ultimate dissolution of the joining church. Specifically, you will need to do the following:

Review corporate documents of joining church. After identifying that donation/dissolution is the route that the joining church wants to take, the church’s corporate documents should be carefully reviewed to determine whether the documents contain any form of reversionary clause that may restrict the church from donating assets only to a certain organization or church upon dissolution. Oftentimes, an organization’s corporate documents contain a reversionary clause that restricts the church from donating to any organization other than the local or national denominational body that the church historically was a part of. If this is the case, and the joining church wants to donate its assets to an organization other than the one identified in its corporate documents, it will be necessary for the joining church to amend its corporate documents and include a revised dissolution clause that permits the joining church to donate its assets to any organization that has been recognized as a 501(c)(3) tax-exempt organization.

Governing body of the joining church must authorize donation of assets and dissolution. The determination to dissolve must be made by the governing body of the joining churches. In some churches, this is the board of directors. Other churches require a congregational vote to dissolve. To determine who has authority to make this decision, the joining church will need to carefully review its corporate documents. The provisions of the joining church’s corporate documents apply and must be strictly followed even if, in practice, the church does not follow the bylaws. After holding a board or congregational vote, the joining church should properly document the decision either in a resolution or minutes of the meeting.

Governing body of the lead church should vote to accept donation of assets. Just as the joining church must vote and properly document its decision to dissolve and donate all assets, the lead church should also vote to accept the assets. In some situations, the lead church will be establishing a satellite campus where the joining church is located. If this is the case, the joining church should also vote to establish the satellite campus. Again, all decisions should be properly documented and retained in the organization’s corporate records.

Identify all assets, liabilities, and outstanding contracts. The joining church will need to make a detailed list of all assets and liabilities. Assets, such as buildings, land, vehicles, sound equipment, chairs, and cash should be inventoried. It is helpful to create a spreadsheet that identifies the item and an approximate fair market value of each item. For large assets, such as property and vehicles, related documents, such as deeds or title documents, should be compiled for review. As further discussed below, in the case of the transfer of real property (such as land or buildings) or titled documents (such as vehicles), new documents will need to be drafted and executed to effectuate the actual transfer of these assets.

In addition, the joining church will need to compile a list of all outstanding liabilities. Liabilities include amounts owed to vendors, including amounts owed for any loans. The joining church should also compile all vendor contracts that it currently has, including lease agreements, copier agreements, and so on. These contracts will be terminated upon dissolution.

Pay all liabilities. As previously discussed, a donation/dissolution is appropriate in situations where the joining church does not have existing debt or liabilities at the time of dissolution. This means that the joining church either does not have any debt or it has the ability to pay off existing debt prior to dissolving. If the joining church has debt, it should pay these amounts and maintain appropriate documentation regarding such payments.

Identify and address restricted gifts. After paying off all liabilities, the joining church must also make sure that it has returned any designated gifts that have not been utilized for the purpose for which they were specifically given. For example, if the joining church received a gift that was restricted for the use of the church’s building funds, the joining church either needs to return the donation or request the donor’s permission to include the gift as a general asset that will be donated to another tax-exempt organization upon the church’s dissolution.

Donation of assets. Once all liabilities have been paid and restricted gifts are either returned or designated by the donor for use (such as for donation), the joining church will proceed to donate all remaining assets to the lead church. Assets include all buildings, sound equipment, tables, vehicles, money, and so on. In the event the joining church is donating real property (such as land or buildings), it will need to transfer the property by deed and then properly record the deed with the local county clerk. The property records should reflect the donation of the property to the lead church and show the lead church as the new owner of the property.

Filing dissolution information. It is important for the joining church to formally dissolve its corporate existence after all of its assets have been transferred to the lead church. This is accomplished by filing the appropriate articles or certificate with the state in which the church is incorporated. This step is often ignored by churches because it is the last one to be addressed. However, as discussed above, it is not a good idea to leave an empty corporate shell in existence for liability reasons. Failing to dissolve the corporate entity leaves all of the church’s officers, directors, and employees susceptible to legal claims asserted against the church, even if the church is no longer operating. So long as the church’s corporate shell exists, it can still be sued. For this reason, it is imperative that the joining church’s corporate existence be formally dissolved.

Even though the donation/dissolution is the cleanest and quickest method and, overall, is a great option because it is appropriate in a wide variety of situations, there are a number of steps that must be taken in order to ensure that the process is correctly performed.

Issues for all transactions

Corporate documents

A fundamental legal issue that must be considered, especially by the joining church, is to carefully examine the church’s existing corporate documents for any guidance. A threshold question that is often, but not always, answered in the corporate bylaws is, “Who is empowered to authorize the dissolution?” A related and sometimes difficult issue for a member-driven congregation is, “Who is actually qualified as a member?” It may be prudent to carefully scrub the membership roll, publicly and while giving notice, to determine who will be eligible to authorize the dissolution. It is important to have a sense of who is able to vote and legally authorize the dissolution. While it is fundamentally true that these transactions are “religious questions” not subject to state interference, it is also true that such transactions must occur in accordance with the state’s procedures and these often entail the submission of affirmations and/or evidence that the process for authorizing dissolution has been consistent with existing bylaws.

Moreover, it is not a rare occurrence for a joining church to have to amend its own bylaws in advance of authorizing a transaction. This may be due to the need to remove any reversionary clauses that might exist, (for instance, “If the church is ever sold, then the assets shall revert to …”). In some states and in some denominations there is a tradition of having the bylaws reflect that the assets revert to a like-minded church or denomination. This must be carefully considered and dealt with or the transaction will be subject to a collateral attack and may not even make it through the title company’s due diligence efforts. Therefore, it is always best for a church to keep their corporate documents up to date.

Deed restrictions

A related issue that is important to highlight is to not only look to the bylaws and other corporate documents, which may be amended by following the appropriate procedures, but also to give careful attention to the deed of conveyance that brought the church into title in the first place. In some parts of the country, there can be significant deed restrictions that can greatly alter the positive trajectory of any proposed transaction. If the church, for instance, has significant debt and also has a significant restriction in its deed such that the market significantly discounts the property, then a problem may exist. Imagine a situation where there is significant debt, but the deed the church took to get the property states that “the property will only be used as a church and in such case as it is ever sold or dispossessed of its use as a church, it will revert to a particular family, or, that the property may be sold but can never be used for a commercial purpose that includes the sale of alcohol” and a restaurant wants to purchase the property. These kinds of deed restrictions can be much more time-consuming and costly to deal with and may make it much more difficult to manage the transaction process. It is best to know what deed restrictions exist up front.

Employees

Early in the process, churches should have the courage to ask not only, “Which organization survives?” (which, of course, may be a no-brainer in some cases from a financial and operational standpoint), but also should ask the harder and more specific question, “Which employees will remain and what will be their respective roles?” Legally, the remaining church employees likely will need to sign new employment agreements, and anyone with access to children will need new background checks performed. Also, any new volunteers will also need to be appropriately screened and re-qualified.

A potentially more important issue is to boldly initiate a full and frank discussion as soon as practical about the future roles and authority of all the employees involved. This is the big elephant in the room and it should be acknowledged and discussed prior to the completion of the transaction. This will entail fairly high-level discussions and some degree of confidentiality to work through these issues in a way that will increase the possibility of a successful integration. Ideally, this kind of discussion will occur in advance of any legal due diligence and certainly before the drafting of the plan of merger or other transaction documents.

Real property

Assuming the church owns its property free and clear, new deeds will need to be drafted and recorded if the property is going to be conveyed to the surviving church or ultimately sold/donated to a third-party, nonprofit entity. A real estate agent and title company will ensure that any transfer occurs according to the relevant legal procedures. Also, as discussed above, it is important to pay close attention to any current deed restrictions that may be an issue for either the surviving church or a third-party purchaser/donee. Also, if the selling/donating church’s property is subject to a mortgage, the debt will likely need to be paid in full or discussions will need to occur with the lender in order to draft new loan documents. It’s very possible for the surviving, purchasing, or donee church—if it seeks to retain the other church’s property—to either pay off the mortgage or negotiate better terms, depending on the respective financial conditions of the parties.

If the church’s property is subject to a commercial lease agreement, you need to contact an attorney while you initiate your own review and discussions with the landlord. Ideally, you would address the lease situation in advance of the transaction process. The church should know exactly where it stands with respect to its current lease, whether the current lease can be terminated, and what it may mean for the surviving, purchasing, or donee church to be potentially stepping in its shoes and be responsible for performing under the lease if it cannot be terminated.

Personal property

As part of the due diligence process, the merging entity will need to inventory all of its personal property, including books, equipment, nursery furniture and toys, computers, desks, phones, and so on. It is useful to obtain a schedule of fixed assets and their locations, any Uniform Commercial Code filings, a schedule of equipment leases, and a schedule of sales and purchases of equipment in the prior three years. Aside from the physical inventory list, it is also necessary to provide an inventory of outstanding vendor contracts and other commitments.

All material agreements that encumber real or personal property owned by the church, including mortgages, pledges, security agreements or financing statements, if any, should also be examined. It is also helpful to obtain a list of any vendor or service providers who, for whatever reason, have expressly declined to do business with the church.

Restricted gifts

It is important for merging churches and churches that are going to dissolve as a result of the above transactions to examine their restricted donations or designated funds given to their church. Donations or funds that are given for a designated purpose must be used for such purpose(s). In some states, the nonprofit (such as a church) is under a fiduciary duty to ensure that the funds are only used for their restricted or designated purpose. Therefore, it is important that churches deal with restricted gifts and designated funds before getting too far into the transaction process. The easiest way to find out whether the restricted funds can be transferred to the new church or used for a purpose other than the one previously indicated is by directly asking the donor. If the donor agrees to remove the restriction, change the purpose, or allow the restricted funds to be transferred to the surviving church, then such a change should be made in writing.

However, there is a strong possibility that some donors may no longer be at the address the church has on file or may no longer be living. The Uniform Prudent Management of Institutional Funds Act (“UPMIFA”) governs such circumstances and other issues regarding restricted gifts. UPMIFA has been enacted by many states in some form or fashion, so the church should examine and understand the UPMIFA laws in the state where the church is incorporated. If all of the avenues above have been exhausted, the church may be forced to go to court and see if the judge will remove the restriction.

It is also possible that some donors may simply request that the donation be returned to them instead of changed or transferred. This situation is likely rare, however, because the donor has probably already taken a charitable deduction for the donation at the time it was given. The IRS has stated that if a donor receives a donation back from the charitable entity, the donor must include such amount in the taxpayer’s gross income in the year received. Therefore, many donors will have no interest in paying tax on the returned donation and would allow the donation to be transferred or the restriction removed. If, however, a request is made to return the donation to the donor, the church should consult with legal counsel in determining whether to return the donation and the terms of the refund.

Tax reporting

The most precious asset a church has is its tax-exempt status. Tax issues and reporting requirements must be examined to ensure protection of the church’s tax-exempt status. The first important tax issue that must be considered when a merger between two or more churches occurs is their tax-exempt statuses. It is best that none of the parties take any action that would jeopardize their tax-exempt statuses because the surviving, purchasing, or donee church will continue to perform exempt activities and will need its exempt status. In IRS private letter ruling (“PLR”) 9314059, two exempt organizations proposed a plan to merge the two existing exempt organizations into one surviving organization. The surviving organization would remain in existence and the other organization’s assets and liabilities would be transferred to, and assumed by, the surviving organization and then would dissolve. The business purpose for the merger was to lessen the administrative burdens of operating two exempt organizations and eliminate duplicative administrative services. The IRS concluded that because the surviving organization after the merger would continue to promote its exempt purposes and the merger of the two organizations had a causal relationship to the furtherance of the surviving organization’s exempt purpose, the surviving organization’s exempt status was unaffected by the merger of the two organizations.

So, will the surviving church maintain its tax-exempt status? Section 508(a) of the Internal Revenue Code, as amended, (the “Code”) provides that a new organization organized after October 9, 1969, shall not be treated as an organization described in section 501(c)(3) of the Code unless it has given notice that it is applying for recognition of such status. Therefore, an issue arises as to whether the surviving church would be considered a “new organization” for purposes of section 508(a) of the Code and be required to apply for recognition of such status. In PLR 9314059, the IRS concluded that the surviving organization was not considered a new organization, meaning notice as described in section 508(a) of the Code was not required.

Another important tax issue is whether the merger or acquisition would give rise to unrelated business income tax. Section 511 of the Code imposes a tax on unrelated business income of organizations described in section 501(c)(3) of the Code. Section 513 of the Code defines “unrelated trade or business,” as any trade or business the conduct of which is not substantially related to the exercise or performance by such organization of its charitable, educational, or other purposes or function constituting the basis for exemption under section 501 of the Code.

Section 1.513-1(d)(2) of the Treasury Regulations provides that a trade or business is “related” to the exempt purposes only where the conduct of the business activity has a causal relationship to the achievement of any exempt purpose, and is “substantially related” for purposes of section 513 of the Code only if the causal relationship is a substantial one. Thus, for the conduct of a trade or business from which a particular amount of gross income is derived, to be “substantially related” to purposes for which tax-exempt status is granted, the production or distribution of goods or the performance of services from which the gross income is derived must contribute importantly to the accomplishment of those purposes.

The IRS concluded in PLR 9314059 that the merger between the two organizations would contribute to the accomplishments of the surviving organization’s exempt purposes; therefore, the transfer of assets with respect to the merger was related to the furtherance of the surviving organization’s exempt purposes. Because the merger was related to the furtherance of the surviving organization’s exempt purpose, the transfer did not result in unrelated business income pursuant to sections 511 through 513 of the Code.

Although the IRS in PLR 9314059 concluded that the merger did not result in unrelated business income, there are several other reasons why the IRS has generally concluded that mergers, acquisitions, or consolidations do not produce unrelated business taxable income. First, section 512(b)(5) of the Code provides that all losses from the sale, exchange, or other disposition of property shall be excluded from unrelated business taxable income. Second, in PLR 9738055, the IRS concluded that the transfer of assets through a merger or similar transaction is a contribution, which does not give rise to unrelated business income for the donor and donee. Third, the IRS concluded in PLR 9530036 that the proposed merger and transfer of assets was a “one time event” and thus did not possess the characteristics of a regularly carried on trade or business within the meaning of section 513 of the Code.

The tax implications of the transactions discussed in this article must be fully examined by a tax attorney or tax professional prior to the transaction taking place. Each transaction is different and none of them are worth risking a church’s tax-exempt status.

State reporting

Churches must be very careful to follow state laws and reporting requirements when dissolving or merging with another church. Each state’s laws vary with respect to all different aspects of a nonprofit organization’s incorporation, operation, and dissolution. For example, Texas law prohibits a Texas nonprofit corporation from merging with another entity if the Texas nonprofit corporation will lose or impair its charitable status as a result of the merger. In California, the attorney general must approve certain transactions when a nonprofit is involved. It is important to examine state law to make sure all laws are followed, the appropriate paperwork is filed with the state and the appropriate state agencies are involved.

Although every state is different, the church is generally required to file the articles of merger or a certificate of merger with the secretary of state’s office. The dissolving corporation will be required to file articles of dissolution or a certificate of dissolution with the office.

While some state laws are very similar, it is always prudent to understand the state law where the church was incorporated. In Texas, for example, the Business Organizations Code section 22.251 provides that the directors must approve a plan of merger, if there are no members of the corporation. If the corporation is managed by its members then, if certain requirements are met, the members can approve the plan of merger. The requirements before a merger takes place are similar, under Texas law, to when the nonprofit corporation sells all or substantially all of its assets. The directors must vote to approve the sale of all or substantially all of the nonprofit corporation’s assets, unless members manage the corporation.

The church must also, if they are dissolving, follow the state requirements for dissolution. In Texas, the directors must vote to dissolve the corporation (unless the corporation is managed by members). The directors in charge of winding up the nonprofit corporation must also pay close attention to the state laws in order to avoid any potential personal liability resulting from the rules not being closely followed.

Final Thoughts

For a host of reasons, mergers, acquisitions, and donations/dissolutions of churches are here to stay. It has taken a tough economy and other struggles for the nonprofit world to discover that these transactions can actually benefit both parties in certain situations. Although the process and the details can seem exhausting, the end result is a potentially larger and more financially robust and stable church where its members can continue to promote the church’s mission, ministry, and good works in its community and beyond.

As it says in Proverbs, “A house is built by wisdom and becomes strong through good sense” (Proverbs 24:3, NLT). This verse emphasizes the good sense that each church will need to exercise to make sure that its transaction is a success and in the best interest of the church. Each church should make sure it assembles a good team of legal and accounting professionals, who are vitally important to making the transaction a success. Each church should also make sure it picks the right church leaders to work with the members of the church, the pastors of the church, and the professionals assisting the church. And above all, make the Lord the main part of the process. “For in him all things were created: things in heaven and on earth, visible and invisible, whether thrones or powers or rulers or authorities; all things have been created through him and for him. He is before all things, and in him all things hold together” (Colossians 1:16-17, NIV).

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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