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.
- 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.
- 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.
- 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:
- 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.
- 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.
- 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.
- 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.
- 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).