The notion that churches pay excessive salaries and benefits to pastors and staff sounds delusional. In fact, excessive compensation is a relatively rare occurrence. But when it happens, excessive compensation often becomes public, scandalous, and potentially damaging to the reputation of the church as a whole. Huge houses for ministry leaders, air-conditioned houses for their pets, fleets of fancy cars, and a general lack of financial transparency tends to get the attention of certain people—including the media, federal regulators, and United States senators.
In 2007, Sen. Chuck Grassley (R-Iowa) launched an investigation into the financial practices of six high-profile media ministries. The summary of the probe noted that tax provisions affecting churches and religious organizations had not been updated in decades and that many of the same financial accountability issues that were raised in past scandals still exist.
“While the majority of churches and religious organizations operate with policies and procedures that make them accountable to their members, it is the small minority that don’t that are subject to scrutiny by the members and the public, including the press,” the report said.
No allegation of criminal wrongdoing was made against any of the six ministries. However, Grassley’s original investigation has entered a second and more general examination of the self-governance of ministries and nonprofit organizations. This examination will look into a variety of financial issues, including excessive compensation.
Grassley asked the Evangelical Council for Financial Accountability (ECFA) to conduct a thorough review of the situation, and ECFA in turn created the Commission on Accountability and Policy for Religious Organizations. The 15-member committee is chaired by Michael Batts, managing partner of an accounting firm that serves non-profit organizations and their affiliates. Members were selected to represent a broad crosssection of the religious community. (Editor’s Note: Richard Hammar, senior editor of Church Law & Tax Report, is a member of the committee.)
“Rather than immediately pursuing the possibility of legislation, the senator decided he would like to get input from the broader religious community,” said Batts, who also is an editorial advisor for Church Law & Tax Report.
The committee will explore these issues:
- Whether churches should file the 12-page IRS Form 990 (also known as Return of Organization Exempt from Income Tax) that other nonprofit organizations must file.
- Abuses of the clergy housing allowance, and whether legislation is needed to correct them.
- Repeal or modification of the current prohibition against political campaigning by nonprofit organizations.
- Whether legislation is needed to clarify the rules regarding love offerings taken from the congregation and given to clergy.
The practice of excessive compensation has also been a source of media scrutiny.
“They have tended to focus on charity leaders who earned high compensation from organizations that the public assumed to be very charitable,” said Dave Travis, managing director of Leadership Network, an organization devoted to innovation and training for church leaders.
Most churches, due to their modest means, are not at high risk of excessive compensation.
“For the churches we deal with here at NACBA, who are just typical churches across America, pastors being underpaid is more of an issue,” said Simeon May, chief executive officer of the National Association of Church Business Administration.
Nevertheless, churches should be aware of the potential of excessive compensation and be diligent in abiding by all applicable laws. There are parts of the IRS excessive compensation guidelines that all churches need to be aware of.
Definition by comparison
Excessive compensation has not yet been precisely defined by the Internal Revenue Service or the courts, but it is generally understood to occur when there is compensation in excess of what a “reasonable person” can expect to be paid for a specific occupation or task. Comparing the position in question with others of similar complexity, context, and responsibilities can identify this level of compensation.
“From a ministry standpoint, excessive compensation is defined as a pastor being paid more than the going rate for ministerial services,” said May. “A pastor of a particular church might be paid $200,000 a year. The IRS might do research and decide that churches of that size typically only pay their pastor $100,000 a year. So they think there is a $100,000 excess benefit transaction.”
When a church or ministry pays excessive compensation, it is at risk for two kinds of penalties: loss of its tax-exempt status (a penalty the IRS has been reluctant to impose) or the assessment of additional excise taxes called “intermediate taxes” on those who receive the excessive benefits. These taxes are equal to 25 percent of the amount of the excessive benefit. If the situation is not corrected by the time the IRS assesses the 25 percent tax, it can assess an additional tax of up to 200 percent of the excess benefit.
If the IRS determines that an organization manager knowingly approved an excess benefit, that manager can be assessed a 10-percent tax (to a maximum of $20,000) on the excess benefit. A “manager” can include any member of a church governing board who votes for a compensation package determined by the IRS to be excessive.
Paying the Pastor
Three quick tips to remember as you evaluate pay levels.
- Salary. Know how much you pay, why you pay it, and how it comparesto people in comparable circumstances.
- Housing allowances. It’s a valuable—and easy—benefit for churches to provide to clergy. Make sure what’s provided actually covers housing expenses,and does not exceed the annual fair rental value of the home (furnished, plus utilities). Don’t forget to document specific terms once a year through official business meeting minutes or through an employment contract.
- Accountable reimbursements. Reimburse business expenses through an accountable plan, which requires proper substantiation within a reasonable time as to date, amount, place, and business purpose. Require any excess reimbursements (in excess of substantiated expenses) to be returned to the church.
—Richard R. Hammar
This excerpt is from the 2012-2013 Compensation Handbook for Church Staff (Copyright © 2011, Christianity Today), available at ChurchLawAndTaxStore.com.
The key to heading off trouble: the manner in which compensation is determined and approved by the governing body of the church.
The first consideration is that the people who determine the compensation are disinterested parties. They cannot be people who are related to, or under the supervisory control of, the person being compensated.
“If a lead pastor’s compensation is determined by a church’s board that is composed of the lead pastor, their spouse, and their children, that would probably be highly suspect by the IRS. That’s an extreme example, but it illustrates the challenge,” Travis said.
Churches need to look outside their walls to see what other professionals in similar occupations with similar responsibilities are being paid. Look for “likes”: like responsibilities and like qualifications. One often-used comparison is that of a lead pastor and a school principal. Look at positions nationally and locally, but be aware of geographical cost-of-living differences.
One way to make this comparison is to use one of the salary compensation studies that are available, such as The 2012- 2013 Compensation Handbook for Church Staff from ChurchLawAndTaxStore.com and NACBA’s MinistryPay.com. Denominations often have pay rates and schedules, and other organizations such as LifeWay and Guidestone conduct compensation studies for churches.
A megachurch with extra concern about excessive compensation may want to commission its own compensation study with churches of similar size, style, and operation, May said.
“If they are questioned by the IRS, they could then have the research to support what they are doing,” he said.
If churches decide to pay a pastor or staff member significantly more than the highest 25 percent of the going rate for a comparable position, then they should first get the opinion of an experienced tax attorney, who can determine that the amount is not unreasonable and would not expose the church to the IRS intermediate sanctions.
Documentation is a key to all compensation decisions. This documentation should include the terms of the compensation and the date of its approval, the members of the board present during the debate and vote on the issue, the comparability data obtained, the actions of any members of the board having a conflict of interest, and documentation of the basis for the determination.
The ability to prove how compensation was set is a crucial factor in avoiding unwanted IRS attention. At issue is the concept of the “rebuttable presumption of reasonableness.”
“This is the idea that the laws and regulations provide specific steps that an organization can take in establishing and documenting the basis of compensation for its leaders,” Batts said. “If those steps [described above] are followed as described in the regulations, then it creates a rebuttable presumption that the compensation is reasonable. This means that the burden of proof now has shifted to the IRS, who would have to overcome the presumption that the compensation was reasonable.”
The special study committee may place this standard of presumption of reasonableness on the table for discussion.
“That process gives organizations across the country a bit of a safe harbor. Lots of organizations believe that’s a helpful protection to have,” Batts said.
Many churches filter the issue of compensation through additional layers of theology and polity. Some churches provide modest compensation to clergy and staff, while others believe they should materially bless their pastors as much as possible.
“One of the big challenges when you start thinking about what constitutes excessive compensation is whether a church or religious institution has a sincerely held doctrinal belief that the church should materially bless its leaders. Now you have the added complexity of a First Amendment issue to contend with. In that sense, it’s not merely a matter of clinical tax law that has to be considered,” Batts said.
Avoiding compensation blind spots
Any church can be tripped up by blind spots, or areas that may not be considered “compensation” by pastors, board, and staff but that are considered so by the IRS. When factored into the overall picture, they could push a church closer to the definition of excessive compensation.These blind spots include:
- Love offerings. Many churches and ministers believe that all money in a love offering should go straight to the recipient as a gift, and should not be considered as taxable income. However, May said, the IRS believes those gifts are a result of the minister’s work and therefore are taxable income. “If the gift is funneled through the church and handled properly, there’s no problem,” he said. If those who give the love offerings have their gifts recorded in the church’s books and receive a charitable contribution credit for their taxes, then the distribution to the recipient should be reported as taxable compensation and included in his or her W-2 and Form 1040. The church must also report these types of gifts as taxable income.
- Expenses. A church’s reimbursements of business expenses are not included in the recipient’s income if the reimbursements are accounted for by the church. If unaccounted for, the IRS could determine that the reimbursements reimbursements are an excess benefit transaction. “Church officials often don’t fully understand or appreciate the requirement for appropriate documentation and don’t realize their leaders could be at risk personally,” Batts said.
- Works made for hire. If a church is the legal owner of a copyright in a work made for hire by its pastor or staff member (such as a sermon, song, or book), it may choose to issue a written transfer of the rights to that work—and its royalties—to its creator. This means the church is in effect paying compensation to the creator in the amount of the royalty. Under this arrangement, if the work happens to become a number one Christian radio hit or a best-selling book, it could generate a high enough income to become excessive compensation.
The general principle to keep in mind is this: compensation is more than salary. It includes the housing allowance, reimbursements, love offerings, and many other elements. Keep in mind the total amount of these pieces when considering whether your church is paying excessive compensation.
If there is a suspicion that your church is paying excessive compensation, the first step is to contact an attorney with skill in this area, Batts said. The attorney will first investigate whether there really is excessive compensation and then determine a course of action in dealing with the IRS.
Outcome: enhanced credibility
The ECFA commission’s goal is to present a set of recommendations to Sen. Grassley. No strict deadlines have been set for the work to be completed. Batts said the work could extend through 2013, but hopes that the committee can come up with a set of recommendations sooner than that.
“Our objective as a commission is going to be to address these issues,” he said. “Our hope is that the outcome enhances the credibility and the confidence people place in the church and religious communities.”