Bonuses: Proceed with Caution

Churches must closely follow specific rules or face IRS scrutiny.

I’m often asked this question: Is it legal to pay bonuses to pastors or employees at a church? The short answer is yes. There’s no prohibition on the payment of bonuses by a nonprofit organization to its employees. The only requirement is that the bonus, as part of the employee’s total compensation, is reasonable.

If you are paying bonuses, you have to take that bonus into account when determining whether or not total compensation is reasonable. In other words, a bonus must be reasonable when it’s viewed as part of the total compensation for the employee.

The importance of parameters

There’s no law or rule that says your church has to formally define a bonus plan. That means your church’s board could simply decide that the merits of one or more individual’s work warrants additional compensation that can be paid as a bonus.

For instance, board members could decide to make additional payments of certain amounts at a specified time, such as at year’s end. The board would then need to set parameters—or limitations—to ensure compensation is not excessive or unreasonable. The bonus program really needs to be stated as a range of absolute amounts of overall compensation, including the bonus that can be paid to any individual.

So, what happens if a church decides to give a bonus based on performance and an employee underperforms?

If a bonus is not paid, the board should document the decision and the basis for not paying it. But if a bonus is paid, even though the individual underperforms, then the board needs to document a justifiable reason for paying the bonus in light of the parameters or rules set in the bonus compensation plan.

A bonus is not a commission

Sometimes a bonus looks more like a commission rather than a bonus for performance. And that’s a big problem.

What do I mean? One example would be a bonus paid based upon the amount raised in a capital campaign. Or what if you had a bonus plan based upon the number of new salvations, or new members, or new baptisms, or new people who join the church or who begin tithing, and so on?

Some of these examples seem rather ridiculous, but they serve to make a point: Even if well-intentioned, such a bonus structure can trigger special IRS scrutiny because the compensation arrangement starts to look like a commission structure and possibly the distribution of net earnings, which is prohibited for nonprofit organizations. And it’s inurement. And it’s a no-no.

Set a ceiling

After considering the potential pitfalls, you still may decide to come up with some type of a percentage compensation program. You go to Pastor Smith and say, “We’re going to give you a bonus if X, Y, and Z happens.” Let’s say X, Y, and Z happened ten times more than you ever imagined it would and it happened all of the sudden. It could result in the pastor getting, for example, 300 percent or three times more than what could be considered “reasonable compensation.”

That’s why a solid, board-approved bonus program should place a ceiling on the amount of the bonus to be paid. A ceiling is a safeguard against any large windfall and makes it easier to justify the compensation as being reasonable. It also helps you avoid the appearance of possible inurement.

The board’s fiduciary role

Your church’s board plays a very important role in the annual review of compensation and its approval, including any bonus awarded to employees. And the Federal Tax Law has evolved to the point that boards are considered to have an obligation to participate in setting the parameters of compensation, budgeting, and other fiduciary responsibilities for a church. And that would include anything pertaining to bonuses.

A final caution

Can you pay bonuses? Yes. Is it a treacherous area? Yes, because it’s a hot-button with the IRS. If you don’t structure it right or it’s not properly documented, it’s a gotcha. And I don’t want you to be gotten by the IRS.

David Middlebrook leads the Church Law Group practice section for Anthony & Middlebrook, PC. He is an editorial advisor for Church Finance Today.

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