IRS Private Letter Rulings 200435019, 200435020, 200435021, 200435022
Article summary
. In a series of four rulings published in August of 2004 the IRS for the first time assessed “intermediate sanctions” against a pastor as a result of “excess benefits” paid to him (and members of his family) by his church. Intermediate sanctions are substantial excise taxes the IRS can impose on persons who receive “excess benefits” from a tax-exempt organization. The IRS concluded that a pastor’s personal use of church assets (vehicles, cell phones, etc.) and nonaccountable reimbursements (not supported by adequate documentation of business purpose) that a church pays its pastor, are “automatic excess benefits” resulting in intermediate sanctions, regardless of the amount involved, unless they are reported as taxable income by the church on the pastor’s W-2, or by the pastor on Form 1040, for the year in which the benefits are provided. This is a stunning interpretation of the tax code and regulations that will directly affect the compensation practices of many churches, and expose some church staff members to intermediate sanctions. This article will explain intermediate sanctions, summarize the recent IRS rulings, and assess their relevance to pastors and church compensation practices.
Church compensation practices came under close scrutiny by the IRS in a series of four private letter rulings issued in August of 2004. These rulings represent a major tax development that should be understood by every pastor and church treasurer. Unfamiliarity with these rulings will subject pastors to potentially substantial penalties.
The bottom line is this—the IRS concluded that the personal use of church property (vehicles, homes, computers, credit cards, cell phones, etc.) by a pastor and members of his family, and “nonaccountable” payments or reimbursements by the church of business and personal expenses incurred by the pastor and members of his family, were “automatic excess benefits” resulting in intermediate sanctions, regardless of the amount involved, because they were not reported as taxable income by the church on the pastor’s W-2 or by the pastor on his Form 1040 for the year in which the benefits were provided.
Intermediate sanctions are substantial penalties in the form of excise taxes that the IRS can assess against “insiders” who are paid an “excess benefit” by a church or other tax-exempt organization. In the past, such penalties focused entirely on benefits that were unreasonable in amount. The new IRS interpretation exposes any pastor to intermediate sanctions whose church provides a benefit that is not reported as taxable income by either the church or pastor in the year the benefit is provided. Such benefits may be in the form of loans, nonaccountable expense reimbursements, sales of church property at a price that is below market value, or use of church vehicles and other forms of property for personal purposes.
These rulings will impact the compensation practices of many churches, and expose pastors and church board members to potentially strict penalties for certain transactions that are not timely reported as taxable income. It is essential for pastors, church treasurers, and church board members to clearly understand the IRS rulings and their application to church compensation practices. This article will provide church leaders with vital information about this significant development.
In order to understand the recent IRS rulings church leaders must have some familiarity with the concept of intermediate sanctions and an article entitled “Automatic Excess Benefit Transactions under Section 4958” that appeared in the IRS 2004 Continuing Professional Education text. As a result, this feature article is divided into the following four parts:
Part 1: Intermediate Sanctions
Part 2: IRS Article on “Automatic Excess Benefit Transactions”
Part 3: Four Recent IRS Rulings
Part 4: Application to Church Compensation Practices
Part 4: Application to Church Compensation Practices
Here are the key points that pastors, church treasurers, and church board members need to understand about intermediate sanctions.
1. Section 501(c)(3) of the tax 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.
2. Section 4958 of the tax code permits the IRS to assess “intermediate sanctions” in the form of excise taxes against insiders (called “disqualified persons”) who receive an excess benefit from a tax-exempt organization. These taxes are 25% of the amount of an excess benefit, and 200% of the amount of the benefit if the insider does not “correct” the excess benefit (i.e., return it) within the “taxable period” defined by law.
3. A disqualified person includes an officer or board member of an exempt organization, or a relative of such a person.
4. An “excess benefit” is any benefit paid by an exempt organization to an insider in excess of the reasonable value of services performed. It includes
• excessive salaries
• “bargain sales” to an insider (sales of an exempt organization’s property at less than market value)
• use of an exempt organization’s property at no cost, and
• payment of an insider’s personal and business expenses under a “nonaccountable” plan (without a proper accounting of business purpose), unless the payment is reported as taxable income on the insider’s W-2 or Form 1040
5. 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 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: (1) an approved written employment contract executed on or before the date of transfer; (2) appropriate documentation indicating that an authorized body approved the transfer as compensation for services on or before the date of the transfer; (3) written evidence, that existed on or before the due date of the appropriate federal tax return (Form W-2, Form 1099 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.
6. If an excess benefit is treated as compensation by the exempt organization in the year the benefit is paid, the IRS will consider the benefit along with any other compensation the disqualified person may have received to determine whether the total compensation was unreasonable (and therefore an excess benefit transaction resulting in intermediate sanctions).
7. If an excess benefit is not reported as taxable compensation when paid, then 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 “automatic” excess benefit resulting in intermediate sanctions, regardless of the amount of the benefit.
8. 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 W-2 or Form 1040 for the year in which the benefits were paid.
9. Churches that allow staff members to use a church-owned vehicle or other church property for personal purposes, 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 staff member, reports the benefits are 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 on which the 25% excise tax is 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 will further illustrate these rules.
• Example 1. 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 2. 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 3. Same facts as example 2, 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 did not “clearly indicate its intent to treat the benefit as compensation for services when the benefit was paid” (i.e., the benefit was not reported on the pastor’s W-2 or Form 1040), the benefit constitutes an “automatic” excess benefit resulting in intermediate sanctions, regardless of the amount of the benefit. So, even though the total amount 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.” 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 can establish that the excess benefit transaction was due to “reasonable cause” and was not due to “willful neglect,” the IRS would abate the 25% excise tax. However, if the pastor cannot establish both of these requirements, he would be liable for the 25% excise tax even though he corrected the excess benefit transaction by paying $5,000 plus interest to the church, and paid federal income tax on the $5,000 as additional compensation.
• Example 4. Same facts as example 3, 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 5. Same facts as example 4, 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 6. A church’s senior pastor owns his home, and is paid a salary and housing allowance each year by his church. The church owns a parsonage, and this year allows the pastor’s son and daughter-in-law to use it as their residence, at no charge (neither the son nor daughter-in-law is a minister or church employee). The annual rental value of the parsonage is $12,000, but the church does not believe that this constitutes taxable income and so does not report it on the pastor’s W-2 or on any tax form issued to the son or daughter-in-law. The pastor does not report the $12,000 as taxable income on his tax return (Form 1040) for this year. The pastor, as president of the church corporation, is a disqualified person, and so is his son. The church’s decision to allow the pastor’s son to reside in the parsonage constitutes an excess benefit. Since the benefit was not reported as taxable income in the year it was provided, the rental value constitutes an “automatic” excess benefit resulting in intermediate sanctions. 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 $3,000 (25% of $12,000); (2) an excise tax of $24,000 (200% of $12,000); (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.” See example 3 for more information. However, if the pastor cannot establish both of these requirements, he would be liable for the 25% excise tax even though he corrected the excess benefit transaction by paying $12,000 plus interest to the church, and paid federal income tax on the $12,000 as additional compensation. Also, note that 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 7. 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 she does not report any of the $8,000 on the pastor’s 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% of $8,000); (2) an excise tax of $16,000 (200% of $8,000); (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.” See example 3 for more information. However, if the pastor cannot establish both of these requirements, he would be liable for the 25% 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 son are jointly and severally liable for the intermediate sanctions, meaning that the IRS can collect them from either person.
• Example 8. A church collects a “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. Last year the pastor’s love offering was $4,000. Both the pastor and church treasurer assumed that this amount was a nontaxable gift, and 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% of $4,000); (2) an excise tax of $8,000 (200% of $4,000); (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.” See example 3 for more information. However, if the pastor cannot establish both of these requirements, he would be liable for the 25% 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. Also, note that 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 9. 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). 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 did not “clearly indicate its intent to treat the benefit as compensation for services when the benefit was paid” (i.e., the benefit was not reported on the pastor’s W-2 or Form 1040), the benefit constitutes an “automatic” excess benefit resulting in intermediate sanctions, regardless of the amount of the benefit. So, even though the total amount of the allowances ($4,800 per year) would not have constituted an excess benefit had the church reported them as taxable income, the fact that it did not do so makes the allowances an “automatic” excess benefit. This will result in (1) an excise tax of $1,200 (25% of $4,800); (2) an excise tax of $9,600 (200% of $4,800); (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.” See example 3 for more information. However, if the pastor cannot establish both of these requirements, he would be liable for the 25% excise tax even though he corrected the excess benefit transaction by paying $4,800 plus interest to the church, and paid federal income tax on the $4,800 as additional compensation. Also, note that 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.
