Pastor steals ‘love offerings,’ gets three years in prison

Case reveals how ‘love offerings’ raise many complex questions and issues for churches, church leaders.

Bio

State: Texas
Categories: Criminal Liability, Excess Benefit Transactions

Key point 7-21. Embezzlement refers to the wrongful conversion of funds that are lawfully in one’s possession.

A Texas pastor was charged with theft of U.S. currency valued between $2,500 and $30,000 from his church, a third-degree felony.

The pastor pleaded “not guilty,” and the case proceeded to a jury trial.

At trial, the evidence showed that the pastor represented to his church members that he had a “calling” to support a South African church and orphanage in need of financial assistance.

The church and its members directed “love offerings” to the pastor to support the South African church and orphanage.

Tip: “Love offerings” from a church to its pastor almost always constitute taxable income to the pastor.

The church’s elders began questioning the legitimacy of the pastor’s representations, which were later revealed to be false.

The “love offerings” occurred from August 2017 until October 2017.

Pastor sentenced with theft

The jury found the pastor guilty. Following the jury’s guilty verdict, the trial court gave the pastor a three-year prison sentence. The pastor appealed.

A state appeals court found no basis for an appeal and affirmed the trial court’s verdict.

Why this case matters to church leaders

There are aspects to this case that merit consideration by church leaders. Consider the following:

1. Control over funds

The court concluded that the church members’ “love gifts” to the pastor were not tax-free, even though he claimed that he would use them exclusively to help a church and orphanage in South Africa. The reason: the donated funds were not sufficiently subject to the church’s control. It was entirely up to the pastor to decide how the funds were spent. The fact that the pastor failed to use the funds for the church and orphanage in South Africa underscores the problem.

2. Discretionary funds and the ‘constructive receipt’ tax rule

It is a common practice for a congregation to set aside a sum of money in a discretionary fund and give a minister the sole authority to distribute the money in the fund. In some cases, the minister has no instructions regarding permissible distributions. In other cases, the congregation establishes some guidelines, but these often are oral, ambiguous, and nonaccountable. Many ministers and churches are unaware of the potential tax consequences of these arrangements.

The IRS could assert that the full value of the discretionary fund constitutes taxable income to the minister, even if the minister does not benefit from the fund. The mere fact that the minister could benefit from the fund may be enough for the fund to constitute taxable income.

The basis for this result is the “constructive receipt” rule, which is explained in income tax regulation 1.451-2(a):

Income although not actually reduced to a taxpayer’s possession is constructively received by him in the taxable year during which it is credited to his account, set apart for him, or otherwise made available so that he may draw upon it at any time, or so that he could have drawn upon it during the taxable year if notice of intention to withdraw had been given. However, income is not constructively received if the taxpayer’s control of its receipt is subject to substantial limitations or restrictions.

For a discretionary fund to constitute taxable income to a minister, it is essential that the minister have the authority to “draw upon it at any time” for his or her personal use. This means the fund was established without any express prohibition against personal distributions.

EXAMPLE: The Tax Court ruled that a pastor was required to report as taxable income $182,000 in deposits to a church bank account over which he exercised complete dominion and control. This case supports the view that church contributions to discretionary funds over which a pastor has complete control represent taxable income to the pastor. The court concluded:

[The minister] had unfettered access to the funds in the church accounts, and there is no evidence that the church congregation had any say over how those funds were used. Indeed, the only member of the church congregation who testified at trial had no knowledge of the church’s finances, suggesting that [the pastor] did not share any information about church finances with the congregation. The facts show that [he] fully controlled the church accounts, used money in those accounts at will, including to pay personal expenses, and were not accountable to anyone in their congregation for their use of the church funds. Accordingly, we conclude that [the pastor] exercised dominion and control over the church bank accounts. Consequently, all deposits into those accounts, except those from nontaxable sources, are properly includable in petitioners’ gross income. 101 T.C.M. 1550 (2011).

3. Love gifts

This case demonstrates once again that “love gifts” to a pastor represent taxable income and should be so reported by the pastor and the church.

4. Charitable contributions

Contributions by church members to a pastor’s discretionary fund will not be tax deductible by donors, assuming that the pastor has sole discretion on distributions from the fund. This is because charitable contributions must be made to, or for the use of, a “qualified charitable organization.” Section 170(c) of the tax code defines qualified organizations to include, among others, any organization that satisfies all the following requirements:

created or organized in the United States (or a United States possession);
organized and operated exclusively for religious, educational, or other charitable purposes;
no part of the net earnings of which inures to the benefit of any private individual; and
not disqualified for tax exempt status under section 501(c)(3) by reason of attempting to influence legislation, and which does not participate or intervene in any political campaign on behalf of any candidate for public office.

Donations to a pastor earmarked for a discretionary fund over which he or she exercises sole dominion does not satisfy this definition.

5. Excess benefit transaction

The IRS can impose an excise tax against a “disqualified person,” and in some cases against church board members individually, if excessive compensation is paid to the disqualified person. Most senior pastors will meet the definition of a disqualified person. These taxes, known as intermediate sanctions, are substantial (up to 225 percent of the amount of compensation the IRS determines to exceed reasonable compensation).

As a result, governing boards or other bodies that determine clergy compensation should be prepared to document any amount that may be viewed by the IRS as excessive. This includes salary, fringe benefits, and special-occasion gifts. If in doubt, the opinion of a tax attorney should be obtained.

The IRS deems any taxable fringe benefit provided to an officer or director of a tax-exempt charity (including a church), or a relative of such a person, to be an automatic excess benefit that may trigger intermediate sanctions, regardless of the amount of the benefit, unless the benefit was timely reported as taxable income by either the recipient or the employer.

As a result, the failure of the pastor, or his employing church, to report the offerings as taxable income made them an automatic excess benefit subjecting the pastor, and possibly members of the church board, to substantial excise taxes as noted above.

6. Donations to foreign charities

The pastor’s assertion that he was raising funds for a church and orphanage in South Africa raises the question of the deductibility of contributions made to churches and charities in other countries. The IRS summarizes the rules as follows:

You can’t deduct contributions to . . . foreign organizations other than certain Canadian, Israeli, or Mexican charitable organizations. . . . Also, you can’t deduct a contribution you made to any qualifying organization if the contribution is earmarked to go to a foreign organization. However, certain contributions to a qualified organization for use in a program conducted by a foreign charity may be deductible as long as they aren’t earmarked to go to the foreign charity. For the contribution to be deductible, the qualified organization must approve the program as furthering its own exempt purposes and must keep control over the use of the contributed funds. The contribution is also deductible if the foreign charity is only an administrative arm of the qualified organization. . . .

You may be able to deduct contributions to certain Canadian charitable organizations covered under an income tax treaty with Canada. To deduct your contribution to a Canadian charity, you generally must have income from sources in Canada. See IRS Publication 597 (Information on the United States–Canada Income Tax Treaty) for information on how to figure your deduction.

You may be able to deduct contributions to certain Mexican charitable organizations under an income tax treaty with Mexico. The organization must meet tests that are essentially the same as the tests that qualify U.S. organizations to receive deductible contributions. The organization may be able to tell you if it meets these tests. (IRS Publication 526)

7. Internal controls

This case provides a useful lesson in the importance of maintaining good “internal controls” over a church’s financial resources, and the problems that can occur when internal controls are neglected.

Learn best practices for establishing internal controls with our online course, “Safeguarding Your Church’s Finances.”

8. Criminal consequences

The case illustrates that church leaders like this pastor who mishandle church funds may be subject to both tax penalties and criminal liability.

Zitha v. State, 2023 WL 3526080 (Tex. App. 2023).

Legal Developments

Charity Founder’s Wife Heavily Penalized for Excess Benefit

Tax Court upholds more than in penalties and taxes for unreported compensation left uncorrected.

Richard R. Hammar, Attorney, CPA

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State: Federal
Categories: Excess Benefit Transactions

The United States Tax Court ruled that the wife of the founder of a medical missions charity had received an excess benefit from the charity subjecting her to a “first-tier” penalty of 25 percent of the amount of the excess benefit, and an additional “second-tier” tax of 200 percent of the excess since it had not been returned to the charity.

Note. It is important for church leaders to be familiar with this case since excess benefit transactions are common among churches and expose ministers and possibly others to significant penalties under section 4958 of the tax code. These penalties are assessed against the minister, not the church.

Background

In 2000, a medical missions charity (the “charity”) applied to the Internal Revenue Service (IRS) for recognition of tax-exempt status. In its application, it described its exempt purpose as the operation of a clinic to provide medical examination and treatment services for individuals unable to afford such services. The IRS granted the exemption.

The founder of the charity served as its president from its inception through 2014. His wife (the “petitioner”) held various positions with the charity. In 2000, she was listed as a member of its board of directors. In an annual report filed in October 2012 with the state of Michigan, she was listed as its secretary and treasurer. She was listed as its secretary and as a director on its Form 990 for 2013, and as its secretary on its Form 990 for 2014.

She regularly attended the charity’s board meetings during 2013 and 2014. Neither she nor her husband had an employment contract with the charity in either year.

On its Form 990 (the annual federal information return for tax-exempt charities) for 2013, the charity reported providing the petitioner, in her capacity as “Secretary/Director,” compensation of $21,000. The charity also reported providing compensation of $21,000 to her husband in his capacity as “President/Director.” The charity issued Forms W-2 for 2013, reporting that it had paid the petitioner and her husband $26,000 each. They reported these amounts as wages on a jointly filed Form 1040, U.S. Individual Income Tax Return.

On its Form 990 for 2014, the charity reported that the petitioner and her husband each received “reportable compensation from the organization” of zero. The charity issued neither of them a Form W-2 for 2014. The charity recorded no officer or director salaries in its general ledger for 2014. There is no indication in the minutes of its board meetings that the charity intended to provide compensation to the wife during 2014.

However, during 2014, the charity issued the wife biweekly checks in the amount of $1,000. At trial, she testified that this “was my paycheck because [my husband] put me on [the charity’s] payroll.” These checks totaled $27,000 during 2014.

Also during 2014, the charity issued the wife monthly checks in amounts ranging from $6,000 to $10,000. They totaled $88,000 for the year.

In October 2015, the IRS commenced an examination of the charity’s records. The agency determined the wife received excess benefits from the charity in the amount of $115,000, all consisting of the checks she had received. The IRS determined that the checks were used to defray the personal living expenses of the wife’s family (husband, wife, and eight children).

In 2018 the IRS issued the wife a notice of deficiency for 2014. This notice determined a first-tier excise tax of $28,750 and a second-tier excise tax of $230,000 under section 4958(b) of the federal tax code. The second-tier tax, computed as 200 percent of the excess benefit, is imposed by law when a disqualified person fails to correct the excess benefit transaction in a timely fashion.

The wife sought relief in the Tax Court. Later that year, the IRS issued the charity a determination letter revoking its tax-exempt status retroactively to January 1, 2014. The IRS determined that the charity had failed to establish that “no part of [its] earnings inures to the benefit of any private shareholders or individuals” or that it was “operating exclusively for an exempt purpose.”

The wife and charity appealed the IRS determinations to the Tax Court. However, the charity declined to pursue its challenge to the revocation of its tax-exempt status and so the Court dismissed its appeal for a “failure to prosecute.”

The Tax Court applies Section 4958

Section 4958 imposes an excise tax on a “disqualified person” who engages in an “excess benefit transaction” with a tax-exempt charity. Section 4958(c)(1)(A) defines an “excess benefit transaction” to mean

any transaction in which an economic benefit is provided by an applicable tax-exempt organization directly or indirectly to or for the use of any disqualified person if the value of the economic benefit provided exceeds the value of the consideration (including the performance of services) received for providing such benefit.

An “applicable tax-exempt organization” is an organization described in tax code section 501(c)(3), including churches and other religious organizations.

Section 4958(a)(1) imposes on each excess benefit transaction an excise tax “equal to 25 percent of the excess benefit” and provides that this tax “shall be paid by any disqualified person . . . with respect to such transaction.” If the excess benefit transaction is not corrected in timely fashion, the disqualified person is liable for a second-tier tax equal to 200 percent of the excess benefit.

The Court stressed that Congress enacted section 4958 not to collect revenue but to deter insiders from influencing their organizations in order to receive unreasonable compensation.

Disqualified persons

Intermediate sanctions only apply to “disqualified persons,” which include:

Voting members of the governing body, presidents, chief executive officers, chief operating officers, treasurers, and chief financial officers. The category of “treasurers and chief financial officers” includes “any person who, regardless of title, has ultimate responsibility for managing the finances of the organization.” A person who serves as treasurer “has this ultimate responsibility unless the person demonstrates otherwise.”
Family members of disqualified persons, down to the level of great-grandchildren, are disqualified persons with respect to a charity.

The Tax Court concluded that the wife was a disqualified person because she served as a director and executive officer of the charity, and she was the spouse of a disqualified person (the president).

Excess benefit transactions

The term “excess benefit transaction” is defined by section 4958 as any transaction in which an economic benefit is provided by a tax-exempt organization to a “disqualified person” if the value of the economic benefit provided exceeds the value of the services received for providing the benefit.

Section 4958 further provides that an economic benefit is not treated as consideration for the performance of services unless the charity clearly indicates its intent to so treat it. And, a charity

is treated as clearly indicating its intent to provide an economic benefit as compensation for services only if the organization provides written substantiation that is contemporaneous with the transfer of the economic benefit at issue. If an organization fails to provide this contemporaneous substantiation, any services provided by the disqualified person will not be treated as provided in consideration for the economic benefit.

The “contemporaneous substantiation” requirement can be satisfied in two ways: by timely reporting or by “other written contemporaneous evidence.”

Timely reporting occurs if the organization reports a payment to the disqualified person as compensation on a Form W-2 or a Form 990 filed before the IRS commences its examination. Timely reporting also occurs if the disqualified person reports the payment as income on an original or amended Form 1040 filed before the earlier of the date on which the IRS commences its examination or supplies written documentation of a potential excess benefit transaction.

The “contemporaneous substantiation” requirement can also be satisfied by “other written contemporaneous evidence” showing that “the appropriate decision-making body or an officer authorized to approve compensation approved a transfer as compensation for services in accordance with established procedures.”

Such evidence includes “an approved written employment contract executed on or before the date of the transfer,” other documentation showing that “an authorized body contemporaneously approved the transfer as compensation for services,” and contemporaneous written evidence establishing “a reasonable belief by the . . . organization that a benefit was a nontaxable benefit.”

The Tax Court’s conclusion

During 2014, the wife received biweekly checks totaling $27,000, and monthly certified checks totaling $88,000, for a total of $115,000. If these checks constituted compensation for services provided by the wife to the charity, and were contemporaneously substantiated as noted above, then there would be no excess benefit transaction, since section 4958 provides that an economic benefit is not treated as consideration for the performance of services unless the charity clearly indicates its intent to so treat it.

Reviewing the facts surrounding the wife’s case, the Tax Court concluded:

[The petitioner] supplied no contemporaneous substantiation to show that [the charity] “clearly indicated its intent” to treat the $27,000, much less the $88,000, as compensation for her services. The charity did not report any of those payments as compensation to petitioner on a Form W-2, and petitioner did not report any of those payments as income on her Form 1040. . . . Nor did petitioner supply any other type of contemporaneous substantiation. Specifically, she offered no evidence (such as an employment contract or minutes of board meetings) showing that “the appropriate decision-making body or an officer authorized to approve compensation approved . . . her payments as compensation for services in accordance with established procedures.” In the absence of contemporaneous substantiation, “any services provided by the disqualified person will not be treated as provided in consideration for the economic benefit.” Petitioner is thus foreclosed from contending that the $115,000 she received was not an “excess benefit” because paid in consideration of her performance of services (emphasis added).

Substantial penalties

Based on the Tax Court’s conclusion that the wife was a disqualified person, it then calculated penalties for her.

First-tier tax of 25 percent

Under Section 4958(a), a disqualified person who receives an excess benefit is penalized through a first-tier tax equal to 25 percent of the excess benefit. Based on $115,000 of excess benefits for the wife, the first-tier tax equaled $28,750.

Second-tier tax of 200 percent

Under Section 4958(b), if a first-tier tax is imposed on the excess benefit received by a disqualified person “and the excess benefit involved in such transaction is not corrected within the taxable period,” then, by law, a second-tier tax equal to 200 percent of the excess benefit must be imposed on the disqualified person.

A failure to correct

The Tax Court concluded the wife never corrected the excess benefit transaction. “Correction” means “undoing the excess benefit to the extent possible, and taking any additional measures necessary to place the organization in a financial position not worse than that in which it would be if the disqualified person were dealing under the highest fiduciary standards,” according to Section 4958.

The Tax Court then said:

[The] “taxable period” during which correction must occur (assuming the tax has not yet been assessed) is the period beginning with the date of the transaction and ending on “the date of mailing a notice of deficiency with respect to the tax imposed by section (a)(1)” [i.e., the 25-percent tax]. . . . The “taxable period” during which petitioner was obligated to make correction “thus closed on August 13, 2018, when the notice of deficiency was mailed” [to her by the IRS].

The Tax Court stated:

Petitioner did not correct the excess benefit transactions within the “taxable period.” There is no evidence that she returned to the charity, at any time, any portion of the $115,000 at issue. Nor did she show that she made any effort to place the charity “in a financial position not worse than that in which it would be if . . . she were dealing [with it] under the highest fiduciary standards.” We accordingly hold that she is liable for a second-tier tax of $230,000 (200% × $115,000).

The availability of abatement

The Tax Court also noted the ability for a disqualified person to abate both the first- and second-tier taxes.

To abate the second-tier tax, which helps further explain the abatement process for the first-tier tax (see below), the Tax Court said:

Section 4961(a) affords a disqualified person an opportunity to avoid the second-tier tax. It provides that, if the taxable event is corrected “during the correction period,” the second-tier tax “shall not be assessed, and if assessed the assessment shall be abated, and if collected shall be credited or refunded as an overpayment.” For this purpose, the “correction period” means, with respect to any taxable event:

the period beginning on the date on which such event occurs and ending 90 days after the date of mailing under section 6212(a) of a notice of deficiency with respect to the second tier tax imposed on such taxable event, extended by—

(A) any period in which a deficiency cannot be assessed under section 6213(a), and

(B) any other period which the Secretary [of the Treasury] determines is reasonable and necessary to bring about correction of the taxable event.

It then added:

Under these rules, the “correction period” will remain open at least until this Court’s decision has become final following any appeal. Section 4961(b) grants us jurisdiction “to conduct any necessary supplemental proceeding to determine whether the taxable event was corrected during the correction period.” Any such proceeding must begin within 90 days “after the last day of the correction period.” Petitioner thus retains the opportunity to avoid assessment and collection of the second-tier tax.

The Tax Court noted that section 4962 provides for non-assessment or abatement of the first-tier tax (25 percent) in certain circumstances, too. The court explained:

To qualify for this treatment, the disqualified person must establish two facts “to the satisfaction of the [IRS].” . . . Specifically, she must show (1) that the taxable event “was due to reasonable cause and not to willful neglect” and (2) that the event “was corrected within the correction period for such event.” . . . The “correction period” for the first-tier tax is the same as for the second-tier tax.

Additional penalty for failing to file Form 4720

The failure of the wife and charity to also timely file Form 4720 with the IRS resulted in an “addition to tax” penalty of $7,313 for the wife, which the Tax Court also upheld.

“Tax-exempt organizations are required to file a Form 4720 to report liability for various excise taxes, including taxes imposed for [excess benefit transactions],” the Tax Court said. But the charity did not file for 2014, leading the IRS to conclude the wife “was therefore required to file a separate return on Form 4720 by May 15, 2015,” which she did not, the Tax Court said.

“To avoid liability petitioner must demonstrate that her failure to file was ‘due to reasonable cause and not due to willful neglect’ [Tax Code section] 6651(a)(1)),” the Tax Court said.

In upholding the additional penalty for the wife, it noted:

Reasonable cause exists “if the taxpayer exercised ordinary business care and prudence but, nevertheless, was unable to file the return within the time prescribed by law. . . . A taxpayer’s belief that no return is required in itself is not sufficient to show that the failure to file was due to reasonable cause.”

The Court concluded that the petitioner failed to demonstrate reasonable cause to justify her failure to file Form 4720. As examples of reasonable cause, the Court cited “postal delays, timely filing of a return with the wrong office, death or serious illness of the taxpayer or a member of his family, [or] the taxpayer’s unavoidable absence from the United States.”

It added:

The Form 4720 is admittedly an exotic species: The obligation to file this return—unlike the obligation to file (say) Form 1040—is far from common knowledge, especially for someone not actually involved in a charity’s operations. Petitioner had received monthly checks from [her charity] for prior years, and we do not believe that she understood that such transactions needed to be reported on an excise tax return. “[I]gnorance of the law, however, does not amount to reasonable cause.”

What this means for churches

This case has many important lessons for church leaders, including the following.

Penalties for excess benefit transaction

If a church or other charity provides compensation or benefits to a disqualified person in excess of the value of services provided in return, and the excess is not “contemporaneously reported” as taxable income on a Form W-2 or the recipient’s Form 1040, then this constitutes an excess benefit transaction subjecting the recipient to the following penalties (known as “intermediate sanctions”):

A “first-tier” penalty of 25 percent of the amount of the excess benefit.
A “second-tier” penalty of 200 percent of the amount of the excess benefit. The second-tier penalty is not discretionary with the IRS.

In this case, the Tax Court concluded that the $115,000 the charity paid the wife was not contemporaneously reported on a Form W-2 or the wife’s Form 1040, and therefore it constituted an excess benefit to her. This triggered the first- and second-tier penalties of 25 percent and 200 percent of the amount of the excess ($28,750 and $230,000, respectively).

Correcting the excess benefit transaction

If the first-tier 25-percent excise tax is assessed against a disqualified person and he or she fails to correct the excess benefit within the taxable period (defined below), then by law, the second-tier 200 percent tax must be assessed.

Section 4958 specifies that the disqualified person can correct the excess benefit transaction by “undoing the excess benefit to the extent possible, and taking any additional measures necessary to place the organization in a financial position not worse than that in which it would be if the disqualified person were dealing under the highest fiduciary standards.”

The correction must occur by the earlier of the date the IRS mails a notice informing the disqualified person that he or she owes the 25-percent tax, or the date the 25-percent tax is actually assessed.

The definition of “disqualified person”

Since intermediate sanctions apply only to disqualified persons (and in some cases managers), it is important for church leaders to be familiar with the definition of “disqualified person.”

The regulations define it 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.

Sanctions assessed against recipient

Intermediate sanctions are assessed against the recipient, not the church or charity.

Imposing an excise tax

An excise tax equal to 10 percent of the excess benefit may be imposed on the participation of an organization manager in an excess benefit transaction between a tax-exempt organization and a disqualified person.

This tax, which may not exceed $20,000 with respect to any single transaction, is only imposed if the 25-percent tax is imposed on the disqualified person, the organization manager knowingly participated in the transaction, and the manager’s participation was willful and not due to reasonable cause.

There is also joint and several liability for this tax, meaning a person may be liable for both the tax paid by the disqualified person and this organization manager’s tax in appropriate circumstances. This tax is explained more fully below.

Treating excess benefit as compensation

An excess benefit is treated as compensation when paid if the exempt organization reports the benefit as taxable income on a Form W-2 or Form 1099-NEC issued to the recipient or if the recipient reported the benefit as taxable income on his or her Form 1040.

Other written evidence may be used to demonstrate that the organization approved a transfer as compensation in accordance with established procedures, which include, but are not limited to, (a) an approved written employment contract executed on or before the date of transfer, (b) appropriate documentation indicating that an authorized body approved the transfer as compensation for services on or before the date of the transfer, and (c) written evidence that existed on or before the due date of the appropriate federal tax return (Form W-2, Form 1099-NEC, or Form 1040), including extensions, of a reasonable belief by the exempt organization that under the tax code the benefit was excludable from the disqualified person’s gross income.

Failing to report excess benefit as compensation

If an excess benefit is not reported as taxable compensation when paid, the IRS will assume that the entire amount of the benefit exceeds the value of any services provided by the recipient, and therefore the entire benefit constitutes an excess benefit resulting in intermediate sanctions, regardless of the amount of the benefit.

Automatic excess benefit transactions for personal use of church property

In four private rulings issued in 2004, the IRS assessed intermediate sanctions against a pastor because of the personal use of church property by himself and members of his family, and the reimbursement of expenses by the church under a nonaccountable plan without any substantiation of business purpose.

Most importantly, the IRS concluded that these benefits were automatic excess benefit transactions resulting in intermediate sanctions, regardless of amount, since they were not reported as taxable income on the pastor’s Form W-2 or Form 1040 for the year in which the benefits were paid.

Churches that allow staff members to use a church-owned vehicle or other church property for personal use or that reimburse business or personal expenses of a staff member (or relative of a staff member) under a nonaccountable arrangement may be engaged in an automatic excess benefit transaction that will subject the staff member to intermediate sanctions under section 4958 regardless of the amount of the benefits.

This result can be avoided if the church or the pastor reports the benefits as taxable income during the year the benefits are received, and they may be partly or completely abated if the pastor corrects the excess benefit within the tax period defined by section 4958.

This generally means returning the excess benefit to the church by the earlier of (a) the date the IRS mailed the taxpayer a notice of deficiency with respect to the 25-percent excise tax, or (b) the date on which the 25-percent excise tax is assessed.

If a disqualified person corrects an excess benefit transaction during the taxable period, the 200-percent excise tax is automatically abated. If the disqualified person corrects the excess benefit transaction during the correction period, the 25-percent excise tax is abated only if the disqualified person can establish that (a) the excess benefit transaction was due to reasonable cause and (b) was not due to willful neglect.

Jeopardizing a church’s tax-exempt status

Section 501(c)(3) of the Internal Revenue Code prohibits tax-exempt organizations (including churches) from paying unreasonable compensation to any employee or other person. A violation of this requirement will jeopardize an exempt organization’s tax-exempt status.

The IRS can revoke an exempt organization’s tax-exempt status if it pays an excess benefit to a disqualified person. However, in most cases, the IRS will pursue intermediate sanctions rather than revocation of exempt status.

One of the requirements for tax-exempt status under section 501(c)(3) is that none of a church’s assets can inure to the benefit of a private individual other than as reasonable compensation for services rendered. The fact that the IRS assesses intermediate sanctions does not preclude a finding of “inurement” that may jeopardize a church’s tax-exempt status. In any excess benefit transaction, both outcomes are possible. The tax regulations specify:

In determining whether to continue to recognize the tax-exempt status of an applicable tax-exempt organization . . . that engages in one or more excess benefit transactions . . . that violate the prohibition on inurement under section 501(c)(3) the [IRS] will consider all relevant facts and circumstances, including, but not limited to, the following—

(A) The size and scope of the organization’s regular and ongoing activities that further exempt purposes before and after the excess benefit transaction or transactions occurred;

(B) The size and scope of the excess benefit transaction or transactions (collectively, if more than one) in relation to the size and scope of the organization’s regular and ongoing activities that further exempt purposes;

(C) Whether the organization has been involved in multiple excess benefit transactions with one or more persons;

(D) Whether the organization has implemented safeguards that are reasonably calculated to prevent excess benefit transactions; and

(E) Whether the excess benefit transaction has been corrected . . . or the organization has made good faith efforts to seek correction from the disqualified person(s) who benefited from the excess benefit transaction. Treas. Reg. 1.501(c)(3)-1(f)(2).

The factors listed in paragraphs (D) and (E) of this section will weigh more heavily in favor of continuing to recognize exemption where the organization discovers the excess benefit transaction or transactions and takes action before the IRS discovers the excess benefit transaction or transactions.

Case studies to illustrate rules

The following case studies will further illustrate these rules. Assume that each senior pastor in these case studies meets the definition of a disqualified person.

Case study 1. A church uses an accountable reimbursement arrangement for the reimbursement of its senior pastor’s business-related transportation, travel, entertainment, and cellphone expenses. The church only reimburses those expenses for which the pastor produces documentary evidence of the date, amount, location, and business purpose of each expense within 30 days. By the end of the year, the church has reimbursed $4,000 of expenses.

Since the church’s reimbursement arrangement is accountable, neither the church nor the senior pastor is required to report the reimbursements as taxable income and the reimbursements are not taken into account in deciding if the church has provided an excess benefit to the pastor.

Case study 2. A church sends its pastor and his wife on an all-expense-paid trip to Hawaii in honor of their 25th wedding anniversary. The total cost of the trip is $8,000. The church treasurer assumes that this amount is a nontaxable fringe benefit and so does not report any of the $8,000 on the pastor’s Form W-2. The pastor likewise assumes that the cost of the trip is a nontaxable benefit.

The church’s payment of these travel expenses constitutes an automatic excess benefit resulting in intermediate sanctions, since it was not reported as taxable income by either the church or pastor in the year the benefit was provided. This is so even though the amount of the benefit by itself, or when added to the pastor’s other church compensation, is reasonable in amount.

This will result in (1) an excise tax of $2,000 (25 percent of $8,000), (2) an excise tax of $16,000 (200 percent of $8,000), and (3) a penalty for failing to file Form 4720 (assuming the church and pastor failed to do so).

If a disqualified person corrects an excess benefit transaction during the correction period, the 200-percent excise tax is automatically abated, and the 25-percent excise tax is abated if the disqualified person can establish that the excess benefit transaction was due to reasonable cause and was not due to willful neglect

For this purpose, reasonable cause means exercising “ordinary business care and prudence.” Not due to willful neglect means that the receipt of the excess benefit was not due to the disqualified person’s conscious, intentional, or voluntary failure to comply with section 4958 and that the noncompliance was not due to conscious indifference.

If the pastor cannot establish both of these requirements, he would be liable for the 25-percent excise tax even though he corrected the excess benefit transaction by paying $8,000 plus interest to the church and paid federal income tax on the $8,000 as additional compensation. Also, note that the senior pastor and his wife are jointly and severally liable for the intermediate sanctions, meaning that the IRS can collect them from either person.

Church board members who approve an excess benefit transaction are subject to an excise tax equal to 10 percent of the amount of the excess benefit—up to a maximum of $20,000 collectively.

Case study 3. A church collected a $4,000 “love offering” from the congregation during the Christmas season last year. The congregation was informed that donations would be tax-deductible, and donations were reported on the annual contribution summary provided to each member. Both the pastor and church treasurer assumed the total amount was a nontaxable gift, so neither reported it as taxable income (on Form W-2 or Form 1040).

The love offering constitutes an automatic excess benefit resulting in intermediate sanctions, since it was not reported as taxable compensation by either the church or pastor in the year the benefit was provided. This is so even though the amount of the benefit by itself, or when added to the pastor’s other church compensation, is reasonable in amount. This will result in (1) an excise tax of $1,000 (25 percent of $4,000), (2) an excise tax of $8,000 (200 percent of $4,000), and (3) a penalty for failing to file Form 4720 (assuming the church and the pastor failed to do so).

If a disqualified person corrects an excess benefit transaction during the correction period, the 200-percent excise tax is automatically abated, and the 25-percent excise tax is abated if the disqualified person can establish that the excess benefit transaction was due to reasonable cause and was not due to willful neglect.

If the pastor cannot establish both of these requirements, he would be liable for the 25-percent excise tax even though he corrected the excess benefit transaction by paying $4,000 plus interest to the church and paid federal income tax on the $4,000 as additional compensation.

Church board members who approve an excess benefit transaction are subject to an excise tax equal to 10 percent of the amount of the excess benefit—up to a maximum of $20,000 collectively.

Case study 4. In Private Letter Ruling 201517014 (2015), the IRS revoked an organization’s tax-exempt status because of its compensation practices. The organization was run by its founder and his wife, who served as its CEO and CFO, and their daughter (collectively, the “officers”). The IRS audited the organization and found the following:

The organization made auto loan payments on vehicles used solely by the officers.
The organization did not maintain any documentation to show the business use of the vehicles used by the officers. No mileage logs were provided with specific dates, miles driven, and locations of travel, and no receipts or business purpose for the use of the vehicles were provided.
The officers used the organization’s corporate credit cards for personal purchases. The amounts were not repaid by the officers and were not reported as compensation.
The organization made no-interest loans to the CEO that were not reported as compensation. There was no contemporaneous documentation of the loan, nor were there any security or repayment provisions.

The IRS noted that “fact patterns suggesting inurement frequently suggest excess benefit transactions between an exempt organization and a disqualified person under section 4958” of the tax code. The IRS noted that the income tax regulations instruct the IRS to consider a variety of factors to determine whether revocation is appropriate when section 4958 excise taxes also apply:

(A) The size and scope of the organization’s regular and ongoing activities that further exempt purposes before and after the excess benefit transaction or transactions occurred;

(B) The size and scope of the excess benefit transaction or transactions (collectively, if more than one) in relation to the size and scope of the organization’s regular and ongoing activities that further exempt purposes;

(C) Whether the organization has been involved in multiple excess benefit transactions with one or more persons;

(D) Whether the organization has implemented safeguards that are reasonably calculated to prevent excess benefit transactions; and

(E) Whether the excess benefit transaction has been corrected (within the meaning of section 4958(f)(6)), or the organization has made good faith efforts to seek correction from the disqualified person(s) who benefited from the excess benefit transaction.

Note. For additional case studies, see the “Compensation” section in the Legal Library.

Ononuju v. Commissioner, T.C. Memo 2021-94 (2021).

Legal Developments

Religious Corporation’s Attempt to Block IRS Summons Rejected by Federal District Court

This case provides a helpful review of some of the protections of the Church Audit Procedures Act that were set forth in section 7611 of the tax code.

Richard R. Hammar, Attorney, CPA

Bio

State: South Carolina
Categories: Church Records, Compensation and Benefits, Excess Benefit Transactions

Key point. The tax code provides several protections available to churches in the event the IRS serves notice of a “church tax inquiry” or “church tax examination.”

A federal district court in South Carolina rejected an attempt by a religious corporation to block an IRS summons seeking the production of the corporation’s bank records at eight banks.

A religious corporation (the “plaintiff”) was incorporated as a nonprofit entity in 1972. In its early years, the plaintiff’s primary function was to produce and broadcast a weekly radio program. At some point, the plaintiff began a weekly faith-based television program. In 2015, the plaintiff was informed by the IRS that it had been selected for audit and that the IRS would be seeking access to its bank records. The plaintiff’s accountant informed the IRS agent in charge of the audit that the plaintiff was claiming church status and all the protections of the Church Audit Procedures Act (section 7611 of the tax code). In response, the IRS sent the plaintiff a “notice of church tax inquiry” listing the following areas of concern:

Whether the plaintiff had engaged in excess benefit transactions with disqualified persons. The IRS noted that the plaintiff’s chief officer was paid $371,445 in “reportable compensation” plus an additional $48,000 in “other compensation,” described as a parsonage allowance. The next highest paid employee received compensation of $125,596, consisting of a base salary and “commission income based on a fixed percentage of broadcast placement revenue.”

Whether the plaintiff had received unrelated (and unreported) business income from the rental of various properties.

Whether all compensation was properly reported on W-2s.

Whether the plaintiff’s claim of church status was warranted.

The notice asked for several items of information regarding the plaintiff’s religious activities, revenue and expenses, and detailed information on compensation paid to the officers. The plaintiff did not respond to these inquiries on the ground that the IRS officer who signed the notice was “director, exempt organizations,” and not a “high level IRS official” required to sign any notice of church tax inquiry by section 7611 of the tax code.

The IRS informed the plaintiff that “because you did not provide the information we requested, we still think an examination of the organization’s books and records may be necessary.” This letter identified the same concerns previously noted (possible excess benefit transactions, receipt of unrelated business income, failure to report all compensation, and claim of church status).

Rather than further pursuing a church tax examination, the IRS issued summonses to the plaintiff’s banks in 2016. The plaintiff sought to quash the eight summonses on the following grounds:

(1) The purpose was improper because the summonses were issued in support of a church tax inquiry that was not properly authorized under section 7611.

The court noted that section 7611 of the tax code, which incorporates the Church Audit Procedures Act, defines a “church tax inquiry” as “any inquiry to a church to serve as a basis for determining” whether the church is exempt from tax due to its status as a church or is subject to taxation for some other reason (e.g., because it is carrying on an unrelated trade or business). IRC 7611(h)(2).

Section 7611 defines a “church tax examination” as any examination of (A) Church Records at the request of the IRS, or (B) the religious activities of any church. IRC 7611(h)(3). “Church Records” is defined to exclude records acquired “pursuant to a summons to which Section 7609 applies.” IRC 7611(h)(4). “Thus, church tax inquiries and church tax examinations are two distinct investigatory tools used for the same purpose and are directed to the church or to records in the church’s custody (as opposed to church-related records held by a third party).”

The court continued:

Presumably because church examinations are more intrusive, section 7611 provides that a church must be offered a conference before a church tax examination is conducted. Church records and activities may, moreover, only be examined “to the extent necessary to determine” liability for tax or whether the entity was, in fact, operating as a church during the relevant period ….

Third-party summonses are governed by section 7609, not section 7611, even when the summons is issued in connection with a church tax inquiry …. Legislative history confirms that section 7611 is inapplicable to third-party summonses …. The House Conference report [in connection with section 7609] stated the “church audit procedures” did not apply to examination of the types of third-party records sought here, explaining as follows: “Records held by third parties (e.g., cancelled checks or other records in the possession of a bank) are not considered church records for purposes of the conference agreement. Thus … the IRS is permitted access to such records without regard to the requirements of the church audit procedures.

(2) The IRS failed to provide the plaintiff with the required tax inquiry notice before issuing the summonses.

The plaintiff claimed that the IRS had failed to provide proper notice that it might seek information from third parties. The court disagreed, noting that the IRS has provided the plaintiff with this information by providing it with a copy of IRS Publication 1, which advises taxpayers that the IRS may “sometimes talk with other persons if we need information that you have been unable to provide.”

(3) The summonses violate section 7611’s prohibition on repetitive church inquiries.

The court noted that “if any church tax inquiry or examination with respect to any church is completed and does not result in [an adverse consequence] no other church tax inquiry or examination may begin with respect to such church during the applicable 5-year period unless such inquiry or examination is approved in writing by the Treasury Secretary or does not involve the same or similar issues involved in the preceding inquiry or examination.” IRC 7611(f)(1).

The court concluded that occasional correspondence from the IRS that did not constitute church tax inquiries did not count in applying this provision.

What this means for churches

This case provides a helpful review of some of the protections of the Church Audit Procedures Act that were set forth in section 7611 of the tax code. They may be summarized as follows:

Tax inquiries and examinations of churches

Congress has imposed special limitations, found in section 7611 of the tax code, on how and when the IRS may conduct civil tax inquiries and examinations of churches. The IRS may only initiate a church tax inquiry if an appropriate high-level Treasury Department official reasonably believes, based on a written statement of the facts and circumstances, that the organization: (a) may not qualify for the exemption or (b) may not be paying tax on an unrelated business or other taxable activity.

Restrictions on church inquiries and examinations

Restrictions on church inquiries and examinations apply only to churches and conventions or associations of churches. They don’t apply to related organizations. For example, the rules don’t apply to schools that, although operated by a church, are organized as separate legal entities. Similarly, the rules don’t apply to integrated auxiliaries of a church.

Restrictions on church inquiries and examinations do not apply to all church inquiries by the IRS. The most common exception relates to routine requests for information. For example, IRS requests for information from churches about filing of returns, compliance with income or Social Security and Medicare tax withholding requirements, supplemental information needed to process returns or applications, and other similar inquiries are not covered by the special church audit rules.

Restrictions on church inquiries and examinations don’t apply to criminal investigations or to investigations of the tax liability of any person connected with the church, such as a contributor or minister.

The procedures described in section 7611 are used in initiating and conducting any inquiry or examination into whether an excess benefit transaction has occurred between a church and a pastor or other insider.

Audit process

The sequence of the audit process is:

If the reasonable belief requirement is met, the IRS must begin an inquiry by providing a church with written notice containing an explanation of its concerns.

The church is allowed a reasonable period in which to respond by furnishing a written explanation to alleviate IRS concerns.

If the church fails to respond within the required time, or if its response is not sufficient to alleviate IRS concerns, the IRS may, generally within 90 days, issue a second notice, informing the church of the need to examine its books and records.

After issuance of a second notice, but before commencement of an examination of its books and records, the church may request a conference with an IRS official to discuss IRS concerns. The second notice will contain a copy of all documents collected or prepared by the IRS for use in the examination and subject to disclosure under the Freedom of Information Act, as supplemented by code section 6103 relating to disclosure and confidentiality of tax return information.

Generally, examination of a church’s books and records must be completed within two years from the date of the second notice from the IRS.

If at any time during the inquiry process the church supplies information sufficient to alleviate the concerns of the IRS, the matter will be closed without examination of the church’s books and records. There are additional safeguards for the protection of churches under section 7611. For example, the IRS can’t begin a subsequent examination of a church for a five-year period unless the previous examination resulted in a revocation, notice of deficiency or assessment, or a request for a significant change in church operations, including a significant change in accounting practices. Bible Study Time v. United States, 2017 WL 897818 (D.S.C. 2017).

Legal Developments

When a Church Dissolves

Distribution of assets raises an array of legal and tax issues requiring legal counsel.

Richard R. Hammar, Attorney, CPA

Bio

State: Pennsylvania
Categories: Church Property, Dissolution, Excess Benefit Transactions

Key point 6-07.04. Church board members have a fiduciary duty of loyalty to their church, and they may be personally liable for breaching this duty by participating in board decisions that place the interests of one or more board members above the interests of the church itself.

Key point 6-15. The procedure for dissolving an incorporated church is specified by state nonprofit corporation law.

A Pennsylvania court addressed the issue of whether a church acted properly when it dissolved due to declining attendance, sold its assets, and transferred most of the sales proceeds to the pastor as compensation for wages that it was previously unable to pay.

A church was established in 1902. In 1999, the church hired a new pastor with a starting weekly salary of $150, out of which $90 was treated as a non-taxable housing allowance. The pastor subsequently received periodic salary increases and, eventually, his entire salary was treated as a housing allowance. He was also paid separately for his maintenance work. As of 2008, his annual salary was $17,930.

In 2007, thirteen members of the church’s congregation unanimously approved the revision to the church’s constitution to provide that “in the event of the dissolution of this corporation, all of its debts shall be fully satisfied, including any compensation and benefits due to its Pastor.”

At an annual congregational meeting in 2008, eight voting members of the church, including the pastor and his wife and two children, voted to dissolve the church and sell the church’s property. They also adopted a motion by the pastor’s son to compensate the pastor for his past service after the sale of the church’s property.

A committee formed to determine the amount of compensation for the pastor proposed to pay him up to $635,000. Between 1999 and 2008, the church’s annual income ranged from $26,474 to less than $35,000.

Later that year the pastor and his wife and son signed an agreement to sell the church’s property to another church for $750,000. A week later, six remaining voting members (including the pastor and his wife and two children) unanimously voted to dissolve the church and approved the compensation package for the pastor.

After receiving a net amount of $690,000 from the sale of the property in 2009, and pursuant to the procedure for dissolving a nonprofit corporation described in the state nonprofit corporation law, the church asked a court to approve its proposed distribution of the proceeds from the sale of its assets. The church informed the court that it “owed its pastor and other employees compensation for periods of time when they were uncompensated due to the church’s financial struggles.”

The state opposed the proposed distribution of the church’s assets on the grounds that the church failed to seek the court’s approval prior to the sale of its assets, and by voting to approve the compensation package the pastor and other members of the church board violated a fiduciary duty imposed by the nonprofit corporation law and engaged in “self-dealing to inure benefits to private individuals.”

The court concluded that the pastor’s claim for compensation for his past service would be unenforceable under contract law. It noted that contracts, to be enforceable, must by supported by “consideration,” meaning that both parties must receive something of value in exchange for their commitments.

The court noted that the church’s commitment to pay the pastor $635,000 in back wages was unenforceable since “past services” are never valid consideration for current obligations and commitments. As a result, the court concluded that payment of additional sums to the pastor in excess of his specified salary would constitute a gift, which would be inconsistent with the charitable purposes of the church.

The church appealed, claiming that the proposed payment to the pastor is consistent with its charitable purposes. It asserted that its members desired to compensate the pastor appropriately and that the church’s constitution also expresses a desire to compensate him adequately. The church also cited the provision of its revised constitution requiring payment of all debts, including any compensation and benefits owed to the pastor, upon dissolution.

A state appeals court dismissed the church’s appeal on a technical ground. It noted that the trial court’s ruling was in the context of the church’s petition to dissolve its corporate status, and as such it was not appealable until the broader issue of dissolution was adjudicated. Once the trial court reaches a decision on the church’s petition to dissolve its corporate status, then the entire case, including the court’s prior ruling addressing the distribution of the sales proceeds, would be appealable as a final order of the court.

What this means for churches

This case addresses a question that often arises when a small, struggling church dissolves, sells its assets, and transfers the proceeds to its pastor or, in some cases, other employees or directors. In many such cases, the justification for distributing the proceeds from the sale of church assets to the pastor is that he or she was not “adequately compensated” in the past and this is a way to make amends. But as the trial court in this case noted, such dispositions of the proceeds from the sale of church assets has a number of potential legal and tax consequences, including the following:

Churches and religious organizations, like all exempt organizations under IRC section 501(c) (3), are prohibited from engaging in activities that result in inurement of the church’s or organization’s income or assets to insiders (i.e., persons having a personal and private interest in the activities of the organization).

Insiders could include the minister, church board members, officers, and in certain circumstances, employees. Examples of prohibited inurement include the payment of dividends, the payment of unreasonable compensation to insiders, and transferring property to insiders for less than fair market value. The prohibition against inurement to insiders is absolute; therefore, any amount of inurement is, potentially, grounds for loss of tax-exempt status. In addition, the insider involved may be subject to excise tax.

See the following section on excess benefit transactions. Note that prohibited inurement does not include reasonable payments for services rendered, payments that further tax-exempt purposes, or payments made for the fair market value of real or personal property. IRS Publication 1828.

1. Disposition of the proceeds of the sale of church assets in the course of a dissolution of a church often is governed by state nonprofit corporation law. The Pennsylvania Nonprofit Corporation Act applied in this case, and it gave the civil courts authority to review the disposition of church assets in the course of a dissolution. The lesson is clear—church leaders should never distribute the proceeds of a sale of church assets to individuals without the assistance of legal counsel to ensure compliance with state nonprofit corporation law.
2. A church board that authorizes the distribution of proceeds from the sale of church assets to a pastor or any other individual may be in violation of their fiduciary duties to the church, which could expose them to personal liability.
3. A church’s distribution of proceeds from the sale of church assets to a pastor or any other individual jeopardizes the church’s tax-exempt status since it may amount to prohibited “inurement” of a church’s resources to the personal benefit of a private individual. The IRS defines “inurement” as follows:
4. The trial court concluded that the $635,000 paid to the minister was not a legitimate debt of the church that could lawfully be discharged in the dissolution proceeding, since the minister provided no “consideration” (value) to the church in return for its commitment to pay this amount. To the contrary, the only “consideration” was the ministers’ past services did not amount to consideration. As a result, the court characterized the church’s proposed payment of $635,000 to the minister as a gift.
5. The payment of an “excess benefit” to an officer or director (or relative) of a church or any other tax-exempt entity may result in substantial penalties called “intermediate sanctions.” These penalties can be as much as 225 percent times the amount of the excess benefit. This tax is paid by the recipient of the excess benefit, which would be the minister in this case.
6. An excise tax equal to 10 percent of an excess benefit may be imposed on an exempt organization’s managers who authorized the payment of an excess benefit to an officer or director (or relative). This tax may not exceed $20,000 with respect to any single transaction, and is only imposed if the manager knowingly participated in the transaction and the manager’s participation was willful and not due to reasonable cause.
7. To be exempt from federal income tax, a church must be organized exclusively for exempt purposes. This requirement is referred to by the IRS as the “organizational test” of tax-exempt status. The income tax regulations specify that an organization is not organized exclusively for exempt purposes unless its assets are dedicated to an exempt purpose, and that an organization’s assets will be presumed to be dedicated to an exempt purpose if, upon dissolution, the assets would, by reason of a provision in the organization’s articles of incorporation, be distributed to another exempt organization.
8. In summary, the distribution of church assets to a minister or other private individual raises an array of legal and tax issues of considerable importance. Such transactions should never be contemplated without the assistance of legal counsel. In re First Church, 2011 WL 2302540 (Pa. Common. 2011).