IRS Private Letter Rulings 200435019, 200435020, 200435021, 200435022
Overview. In four private rulings issued in August of 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 W-2 or Form 1040 for the year in which the benefits were provided. This is a stunning interpretation of the tax code that will directly affect the compensation practices of most churches, and expose some pastors and church board members to intermediate sanctions. This article will explain intermediate sanctions, summarize the recent IRS rulings, and assess their relevance to church compensation practices.
Key point. The lesson is clear. Sloppy church accounting practices will expose ministers, and in some cases church board members, to intermediate sanctions in the form of substantial excise taxes. As a result, it is essential for pastors and church treasurers to be familiar with the concept of automatic excess benefits so that these penalties can be avoided.
What are intermediate sanctions? The tax code prohibits churches and other tax-exempt organizations from allowing any of their assets to “inure” to the private benefit of an individual other than as reasonable compensation for services rendered. As a result, churches and other tax-exempt organizations that pay unreasonable compensation to an employee are violating one of the requirements for exemption and are placing their exempt status in jeopardy.
But the IRS has another weapon it can use to address unreasonable compensation other than revocation of exempt status. Section 4958 of the tax code empowers the IRS to assess intermediate sanctions in the form of substantial excise taxes against insiders (called “disqualified persons”) who benefit from an excess benefit transaction. Section 4958 also allows the IRS to assess excise taxes against a charity’s board members who approved an excess benefit transaction. These excise taxes are called intermediate sanctions because they represent a remedy that the IRS can apply short of revocation of a charity’s exempt status.
In the past, intermediate sanctions targeted benefits that were unreasonable in amount. The new IRS interpretation exposes pastors to intermediate sanctions if their church provides a benefit that is not reported as taxable income (by either the church or pastor) in the year the benefit is provided, regardless of the amount of the benefit. Such benefits include:
- low-interest or no-interest loans
- nonaccountable expense reimbursements of both business and personal expenses
- direct payment of personal expenses
- sales of church property at a price that is below market value
- use of church vehicles and other forms of property for personal purposes
- use of church credit cards for personal or unsubstantiated purchases
While revocation of exempt status remains an option whenever a tax-exempt organization enters into an excess benefit transaction with a disqualified person, it is less likely that the IRS will pursue this remedy now that intermediate sanctions are available.
Who is a “disqualified person”? Since intermediate sanctions apply only to disqualified persons (and in some cases board members), it is important for church leaders to be familiar with this term. The regulations provide helpful guidance. They define a disqualified person 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.
The income tax regulations specify that persons in a position to exercise substantial influence include voting members of an exempt organization’s board; presidents and chief executive officers; and treasurers and chief financial officers. The term disqualified person includes family members of a disqualified person. The regulations define family members as spouses; brothers or sisters; spouses of brothers or sisters; ancestors; children; grandchildren; great grandchildren; and spouses of children, grandchildren, and great grandchildren.
The income tax regulations specify that some persons are not in a position to exercise substantial influence over the affairs of a tax-exempt organization, including employees who receive compensation or other benefits from an exempt organization of less than the amount required of a “highly compensated employee” under section 414(q) of the tax code ($90,000 for 2004) and who do not meet the definitions of family member or substantial influence as defined in the preceding paragraph.
Excise taxes. Intermediate sanctions consist of the following three excise taxes:
(1) An excise tax equal to 25% of the amount of the “excess benefit” (the amount by which actual compensation exceeds the fair market value of services rendered). This tax is paid by the disqualified person directly, not by his or her employer.
(2) If the 25% excise tax is assessed against a disqualified person, and he or she fails to “correct” the excess benefit by returning it, the IRS can assess an additional tax of 200% of the excess benefit. 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% tax, or the date the 25% tax is actually assessed.
(3) If the IRS assesses the 25% tax against a disqualified person, it is permitted to impose an additional 10% tax on any “organization manager” (any officer, director, or trustee) who participates in an excess benefit transaction knowing it is such a transaction, unless the manager’s participation “is not willful and is due to reasonable cause.” This tax is limited to a maximum of $10,000 per manager (but the total tax on all mangers cannot exceed $10,000).
If a disqualified person corrects an excess benefit transaction during the taxable period, the 25% and 200% excise taxes are “abated” (reduced or eliminated) as follows: (1) the 25% excise tax is abated only if the disqualified person can establish that the excess benefit transaction was due to “reasonable cause” and was not due to “willful neglect”; (2) the 200% excise tax is automatically abated.
The presumption of reasonableness. The income tax regulations clarify that compensation is presumed to be reasonable, and a transfer of property, or the right to use property, is presumed to be at fair market value, if the following three conditions are satisfied: (1) the compensation arrangement or the terms of the property transfer are approved in advance by an authorized body of the tax-exempt organization composed entirely of individuals who do not have a conflict of interest with respect to the compensation arrangement or property transfer; (2) the authorized body obtained and relied on appropriate “comparability data” prior to making its determination; and (3) the authorized body adequately documented the basis for its determination at the time it was made. If these three requirements are met, the IRS may rebut the presumption of reasonableness if it “develops sufficient contrary evidence to rebut the … comparability data relied upon by the authorized body.”
Church Audit Procedures Act. The income tax regulations specify that the protections of the “Church Audit Procedures Act” apply to a church’s excess benefit transactions. The Church Audit Procedures Act imposes specific limitations on IRS examinations of churches. These limitations are explained fully in Chapter 12, Section A.8, of Richard Hammar’s 2005 Church & Clergy Tax Guide.
Four IRS rulings. In August of 2004 the IRS issued four private letter rulings that applied the principle of “automatic” excess benefit transactions to a variety of benefits provided by a church to its pastor and members of the pastor’s family. These benefits included:
- use of church credit cards by the pastor, and his wife and son
- church reimbursement of cell phone expenses incurred by the pastor and his son
- church reimbursements of unsubstantiated travel expenses incurred by the pastor and his wife and son
- personal use of church-owned vehicles by the pastor and his wife and son
- “second home” home expenses paid by the church
- home expenses of the pastor’s son paid by the church
- payment of miscellaneous personal expenses on behalf of the pastor and his son, including clothing and department store purchases
The IRS reached the following conclusions: (1) The pastor, and his wife and son, were all disqualified persons. (2) The benefits provided to the pastor and his wife and son were not reported as taxable income (on a W-2 or Form 1040), and therefore they constituted “automatic” excess benefits resulting in intermediate sanctions. (3) Disqualified persons are jointly and severally liable, meaning that the IRS could impose intermediate sanctions on the pastor for the excess benefits the church provided to his wife and son. (4) An initial excise tax of 25% of the amount of each excess benefit provided to the pastor and his wife and son was assessed. (5) The IRS could also impose an excise tax of 200% of the amount of the excess benefits if they were not returned to the church by the earlier of the date the IRS mailed a notice to the pastor informing him that the 25% tax was being assessed, or the date the 25% tax was actually assessed. (6) A disqualified person who is liable for intermediate sanctions is required to file Form 4720 with the IRS. A failure to do so can result in additional penalties.
Application to church compensation practices. Here are the key points that church treasurers and board members need to understand about intermediate sanctions. Churches that allow staff members (who meet the definition of a “disqualified person”) to use a church-owned vehicle or other church property for personal purposes, or that pay for or 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 staff member, 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 (1) the date the IRS mailed the taxpayer a notice of deficiency with respect to the 25% excise tax, or (2) the date the 25% excise tax was assessed.
If a disqualified person corrects an excess benefit transaction during the taxable period, the 200% excise tax is automatically abated. If the disqualified person corrects the excess benefit transaction during the correction period, the 25% excise tax is abated only if the disqualified person can establish that (1) the excess benefit transaction was due to “reasonable cause,” and (2) was not due to “willful neglect.”
The following examples illustrate these rules.
Example. A church uses an accountable reimbursement arrangement for the reimbursement of its senior pastor’s business-related transportation, travel, entertainment, and cell phone 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 church has provided an excess benefit to the pastor.
Example. A church pays its senior pastor an annual salary of $45,000 this year. In addition, it reimburses expenses the pastor incurs for the use of his car, out of town travel, entertainment, and cell phone use, but does not require substantiation of the amount, date, location, or business purpose of reimbursed expenses. Instead, the pastor provides the church treasurer with a written statement each month that lists the expenses incurred for the previous month. The treasurer then issues a check to the pastor for this amount. This is an example of a nonaccountable reimbursement arrangement. Assume that the church reimburses $5,000 under this arrangement this year, and that the amount is reported as taxable income by the church on the pastor’s Form W-2 for this year. Since the full amount was reported as taxable compensation by the church in the year the benefit was paid, it is not an “automatic” excess benefit resulting in intermediate sanctions, Rather, the IRS will consider the benefit along with any other compensation the pastor received to determine whether the total compensation was unreasonable (and therefore an excess benefit transaction resulting intermediate sanctions). A salary of $45,000 plus $5,000 in reimbursements of nonaccountable expenses is not unreasonable, so the IRS will not assess intermediate sanctions.
Example. Same facts as the previous example, except that the church did not report the $5,000 as taxable income on the pastor’s W-2 in the year it was paid, and the pastor did not report it on his tax return (Form 1040) for that year. The church treasurer assumed that the pastor had “at least” $5,000 in business expenses, and so there was no need to report the nonaccountable reimbursements as taxable income. This is a dangerous assumption that converts the nonaccountable reimbursements into an “automatic” excess benefit and exposes the pastor to intermediate sanctions. An “excess benefit” is defined by section 4958 of the tax code as any compensation or benefit provided to a disqualified person in excess of the reasonable value of his or her services. It includes nonaccountable reimbursements of business and personal expenses unless the reimbursements are reported as taxable compensation by the church or pastor in the year they are paid. Since the church’s reimbursements were not reported on the pastor’s W-2 or Form 1040, they constitute an “automatic” excess benefit resulting in intermediate sanctions, regardless of the amount involved. So, even though the total amount ($5,000) would not have constituted an excess benefit had the church reported it as taxable income, the fact that it did not do so makes the transaction an “automatic” excess benefit. This will result in (1) an excise tax of $1,250 (25% of $5,000); (2) an excise tax of $10,000 (200% of $5,000); (3) a penalty for failing to file Form 4270 (assuming the pastor failed to do so). If a disqualified person corrects an excess benefit transaction during the correction period, the 200% excise tax is automatically abated, and the 25% 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.”
Example. Same facts as the previous example, except that the pastor is a church’s youth pastor. Assuming that the youth pastor is not an officer of the church, a member of the governing board, or a relative of someone who is, he is not a disqualified person and therefore is not subject to intermediate sanctions. While the nonaccountable reimbursements constitute taxable compensation, and the failure by the church and pastor to report them as such exposes the pastor to back taxes plus penalties and interest, they are not an “automatic” excess benefit resulting in intermediate sanctions since the youth pastor is not a disqualified person.
Example. Same facts as the previous example, except that the youth pastor is the senior pastor’s son. Assuming the senior pastor is president of the church corporation or a member of the governing board, he is a disqualified person and so is his son. As a result, the nonaccountable reimbursements that were not reported as taxable compensation are an “automatic” excess benefit resulting in intermediate sanctions. The senior pastor and his son are jointly and severally liable for the intermediate sanctions, meaning that the IRS can collect them from either person.
Example. A church pays its senior pastor a monthly car allowance of $400. The church does not require the pastor to substantiate that he uses the monthly allowances for business purposes, and does not require him to return any “excess” reimbursements (the amount by which the allowances exceed actual business expenses) to the church. The church treasurer does not report these allowances as taxable income on the pastor’s W-2), since he assumes that the pastor has “at least” $400 of expenses associated with the business use of his car each month. The pastor reports none of the allowances as taxable income on his tax return (Form 1040). Since the allowances were not reported on the pastor’s W-2 or Form 1040 they constitute an “automatic” excess benefit resulting in intermediate sanctions, regardless of the amount involved.
This article first appeared in Church Treasurer Alert, November 2004.