You may have heard that the Internal Revenue Service hasn’t been auditing churches since 2009.
This is generally true because of the challenge the IRS faces with clearing the hurdles of the Church Audit Procedures Act (IRC 7611). For several years now, the IRS has been unable to finalize regulations related to the law concerning who is a “high ranking” IRS official authorized to approve church income tax audits.
However, based on what I’m told by churches and tax professionals, the IRS is active in church payroll tax audits. These audits are not subject to the IRC 7611 limitations.
Two reasons may be driving this IRS activity with churches:
Limited resources. IRS officials consistently say their funding is tight. In addition, a string of congressional investigations involving the IRS in recent years has cost the agency millions of dollars and diverted IRS staff members from their regular work to instead provide information to Congress.
As a result, there generally appears to be some strain on the IRS’s availability for in-depth audits. However, payroll tax audits generally take a few days, making them easier to schedule and conduct, even with these resource limitations.
The Affordable Care Act. The Employer Shared Responsibility provisions of the Affordable Care Act (ACA) begin to unfold in 2015 for large employers, including churches that meet the definition of a large employer. A large employer is one with the equivalent of 50 or more full-time employees (a full-time employee is an individual employed, on average, at least 30 hours of service per week).
To avoid penalties, a large employer’s health plan must have “Minimum Essential Coverage”; the plan must provide “Minimum Value” (meaning it pays for at least 60 percent of total allowed health costs); and the plan must be affordable.
The IRS has expressed concern that some employers might be classifying employees as independent contractors to stay under the 50-employee threshold and dodge these penalties. A payroll tax audit by the IRS can help identify these misclassifications.
The IRS may never do a payroll tax audit of your church, but from Scripture we know “the noble man makes noble plans, and by noble deeds he stands” (Isaiah 32:8, NEW INTERNATIONAL VERSION). This article will explore how your church can prepare for a payroll tax audit. The potential problems that can arise, if you’re not prepared, can prove costly.
What the IRS reviews
A payroll tax audit may sound less involved than a church income tax audit, leading one to believe it won’t consume much staff time or resources, much less reveal any significant issues. Think again!
Let’s walk through 11 types of records the IRS often requests in church payroll tax audits. It’s worth noting that the IRS rarely audits the most recent year—more than likely, it will look at the earliest open year, which is two or three years back. In general, it’s wise for churches to retain the documents listed below for at least seven years:
General ledger. This shows how much income the church received and how much the church spent during the year.
Forms W-4. Every employee has a Form W-4 to show how much in federal and state taxes the employee elects for the church to withhold from his or her paycheck.
Forms W-2. A Form W-2 shows how much in federal and state taxes the church withheld for an employee for the year.
Ministerial tax status. Most ministers are employees for income tax purposes, but all ministers are self-employed for Social Security with respect to compensation from the exercise of ministry. This is commonly known as the “dual tax status” of ministers. Ministerial status also makes certain tax benefits, such as a housing exclusion, possible.
It’s wise to keep records demonstrating why the church classified someone as a minister. At a minimum, one must be ordained, licensed, or commissioned in order to be considered a minister. In addition, a balance of four other factors are considered. Maintaining documentation regarding all of this is important.
Forms 1099-MISC. Churches must issue a 1099-MISC to any self-employed person to whom the church paid nonemployee compensation of $600 or more during the calendar year. Examples of persons to whom churches may be required to issue a 1099-MISC include evangelists, guest speakers, contractors, and part-time custodians.
Employee expense reimbursements. Every church should have a well-written accountable expense reimbursement plan. It also should have files documenting the reimbursements made under that plan during the year, including all expense receipts containing dates and amounts, the business purposes of the expenses, who was involved with the expenses, and proof that each reimbursement request was submitted within 60 days of when the expense occurred.
Church-owned vehicles. A church should keep records of any vehicles it owned during the year and note any personal use of those vehicles by ministers and staff. For any personal uses of vehicles, the church must calculate the value of those personal miles and report those values as taxable income to respective employees.
403(b) plan payments. Any church that offers a 403(b) plan must keep a copy of the plan document on file and then keep records showing how it complied with its plan document for employees during the year.
Staff gifts for holidays or special occasions. All cash gifts, including love offerings collected by the church to be given to ministers and staff, and cash equivalents (such as gift cards), must be reported as taxable income on employee Forms W-2. Only property or services with a low fair market value (also known as de minimis fringe benefits) may be given and not treated as taxable income (if it would be unreasonable or administratively impracticable to account for it).
Property transfer. The fair market value of any property transferred to a minister or staff member as a gift must be recorded as taxable income.
This may sound like a large amount of records for churches to keep. But in an IRS payroll tax audit, any or all of these records could be requested and examined. Under this type of scrutiny, any number of problems can be identified, proving potentially costly to the church, its ministers, and its staff.
Consider these scenarios:
In a review of the Forms W-4, the auditor discovers incomplete records for each employee. The auditor can propose a penalty for failure to have the appropriate forms in the file for each employee relating to all tax years under audit.
In a review of W-2s, the auditor notices one that shows no federal income tax withholding and asks why. You tell her that the W-2 is for the senior pastor. That leads the auditor to ask why that particular W-2 shows FICA withheld and matched. The auditor observes that the senior pastor (with ministerial status under the tax code) is not subject to FICA—he is subject to SECA calculated on the pastor’s Form SE.
The auditor reconciles the data on Forms W-2 to the general ledger. The dollars posted to the general ledger were higher than the W-2 data. Upon inspection, she finds that Christmas bonuses given to the staff were not reported on either the Forms 941 or Forms W-2 as compensation. Additionally, gift cards had been purchased by the church at intervals during the year, given to the church staff, and recorded in the payroll account but not reported on Forms W-2. Thus, compensation was understated for each affected staff person and for lay employees, resulting in FICA taxes being under-withheld and matched.
The auditor finds an account in the general ledger labeled “Fees Paid.” The auditor asks for the supporting documents for each of these expenses. She finds three payments to individuals for services rendered—in each case over $600 per individual. A Form 1099-MISC was only filed for one of the individuals, so the auditor proposes a penalty for failure to file the Form 1099-MISC to the other two individuals.
For each minister on staff, the auditor asks for a copy of the ordination or licensing documentation and the position description. The church does not have any of these materials. Based on the information provided to the auditor, she takes the position that two of the individuals the church considered as ministers were lay employees, subject to FICA and ineligible for the clergy housing exclusion.
The auditor reviews all expense reimbursements and determines that thousands of dollars of expenses lacked adequate substantiation. The auditor also notices many of the reimbursements were made six months or more after they were incurred, significantly missing the 60-day safe harbor.
All of these issues—and more—really can arise simply as result of an IRS payroll tax audit. Could these issues create a large bill from the IRS? Absolutely!
Before the IRS comes knocking
What can a church do BEFORE it receives a notice of an IRS payroll tax audit? As a part of reviewing the types of records noted above, pay particular attention to these eight common problem spots:
Review the church’s accountable expense reimbursement plan. If you don’t have a written plan, establish one.
Test expense reimbursement substantiation. In some churches, the pastoral staff may not be adequately forthcoming with expense substantiation. Is the business purpose for travel recorded? For meals, does the documentation reflect not only the date and the amount, but who participated in the meal and the business purpose of the meal?
Review worker classifications. Are you treating workers as independent contractors who really have significant employee characteristics? If so, consider using the IRS voluntary classification settlement program: irs.gov/Businesses/Small-Businesses-&-Self-Employed/Voluntary-Classification-Settlement-Program.
Review the 403(b) plan provisions. Be sure that the church is making all employer contributions in agreement with the plan and allowing all eligible plan participants to have pre-tax money withheld and contributed into the plan.
Review taxable and non-taxable fringe benefits. Be sure that all taxable fringe benefits, such as property transfers, Christmas gifts, and more, are reflected on Forms W-2.
Review the personal-use records for all church-owned vehicles. If the church owns one or more vehicles, there is undoubtedly some personal use of the vehicle(s)—which means there is reportable compensation.
Check Forms 1099-MISC filings. Is a Form 1099-MISC being filed for all applicable payments to independent contractors of $600 or more in a year?
Check the completeness of the Form W-4 file. Be sure there is a Form W-4 in the file for each staff member for each year.
If the IRS comes knocking
What should a church do if it receives notice of an IRS payroll tax audit? The two key choices are to say “come on down” or to call your certified public accountant (CPA) or other tax professional for advice. My preference is always to transfer the audit to the office of the tax professionals. Transfer the requested documents to the professionals, and let them deal directly with the auditor. This may seem like a very expensive proposition, but it could save the church a lot of money and grief.