Getting Payroll Right

The payroll taxes reported by 6,000 organizations from across the country are under intensive examinations by the Internal Revenue Service through a new payroll compliance initiative.

Churches should take note of this additional scrutiny for two reasons.

One, among the 6,000 organizations selected, 1,500 are tax-exempt entities. Churches, as well as other nonprofit organizations, may be included since payroll tax examinations are not conducted under the special provisions for church tax inquiries under Internal Revenue Code §7611.

And two, incorrectly reporting the compensation of workers can lead to serious consequences for churches. Church leaders should take special care in this area due to the potential amount of taxes, penalties, and interest that can be assessed for noncompliance.

Whether a church specifically gets reviewed by this payroll compliance initiative or not, all church leaders should use this opportunity to review their own practices, identify any real—or potential—problems, and take corrective measures. A thorough assessment of the following payroll topics can mitigate risk and avoid undue financial penalties for churches and church leaders.

Churches struggle most with classifying a worker as either an employee or an independent contractor. In most instances, the worker’s classification can be determined from the law (although a few gray areas do exist). Unfortunately, churches frequently base a classification on either someone’s personal belief or on what other churches are doing with similar workers.

Employers may classify a worker as an independent contractor to save time, paperwork, and/or money. The significant risk a church takes by choosing the seemingly easy path, though, is the payroll tax liability that arises when one of its workers must be reclassified from independent contractor to employee.

Some common misconceptions regarding worker classification include:

The basic test for worker classification (a full discussion of the process is beyond the scope of this article) revolves around these factors:

In virtually all circumstances, the IRS classifies a worker as an employee unless that person owns a business providing services to the church as well as to other entities.

The following positions are commonly misclassified by churches:

Workers classified by a church as independent contractors who are later classified as employees by the IRS will result in the assessment of taxes, penalties, and interest to the church on the wages paid to misclassified workers. I know of one organization with less than $1 million in annual revenue that paid more than $30,000 in payroll taxes and penalties due to worker classification issues.

Ministers are treated uniquely for payroll, and churches should take care when classifying them. The following key issues should be addressed regarding ministers:

Reportable payroll is more than just what is paid through the normal paycheck and reported through the payroll system used by the church. The essence of tax law is that every benefit granted to an employee/worker is taxable until the Internal Revenue Code allows for it to be tax free. Churches must review every benefit provided to an employee and confirm the proper tax consequences of the benefit. Many benefits can be provided tax free as long as the proper documentation is in place and certain requirements are met.

The following are examples of benefits that may be taxable to an employee if they are not handled through the proper programs:

Other times, churches call taxable income by a different name and then think it isn’t taxable to the employees, such as the following:

Not properly classifying fringe benefits opens a church to additional payroll tax assessments by the IRS. Taxable fringe benefits incorrectly reported can be classified as excess benefit transactions and cause the assessment of intermediate sanctions equaling 225 percent to a key employee and 10 percent to the person who agreed to the benefit. Additionally, the employee could be required to repay the benefit to the church.

Taxable fringe benefits can also be determined in the event an employee is audited by the IRS and has additional taxes assessed. In severe cases, employees may be charged with tax fraud or tax evasion due to the underreporting of their taxable income. Both charges carry severe civil penalties and potential criminal charges.

Don’t forget these three basic responsibilities churches must fulfill as a part of payroll:

Penalties are imposed on employers that do not file the requisite Forms 941/944 or that do not deposit the related payroll taxes in a timely fashion. Churches are not exempt from these penalties. The portion of the payroll tax obligation that is withheld from an employee’s pay is considered to be the “trust fund” portion of the taxes.

The IRS views the lack of remittance of these taxes to be the equivalent of stealing from the employees. Therefore, the penalty for a failure to deposit is high and quickly adds up. Within 16 days from the date the tax is due, the penalty is already assessed at 10 percent of the tax due. If this isn’t paid upon request of the IRS, the IRS can assess an additional 15 percent of the amount due.

The IRS is very unforgiving of organizations that do not pay these taxes. In only rare instances will the IRS be willing to abate the penalties associated with the late payment of payroll taxes. In St. Paul Cathedral School v. U.S., 102 AFTR 2d 2008-7212, the court agreed that the school should be required to pay all the penalties assessed on the late filing of the school’s Forms 941 and the late payment of the related taxes. The school was required to pay the penalties even though the duties to file and pay had been delegated to the school’s bookkeeper and despite the fact that the bookkeeper had stolen the tax money.

The IRS can move through the corporate entity of the church to collect the trust fund portion of payroll taxes from any responsible party. This can be any person with the church that has the authority or the ability to make sure the taxes are properly paid. Therefore, a church treasurer can have the tax liability assessed to him personally, if it is not properly paid by the church. Further, director and officer liability insurance cannot cover these assessments.

Payroll issues present some of the most challenging areas of compliance for churches and religious organizations. Rules tend to be highly technical and not necessarily intuitive. Unfortunately, the consequences of poor compliance in this area can result in monetary damages to employees, employers, and to responsible persons, such as board members, officers, and committee members. To assure that compliance is a high priority, churches should: