IRS Addresses Church Compensation Practices

Part 2 – IRS Article on “Automatic Excess Benefit Transactions”

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 2: IRS Article on “Automatic Excess Benefit Transactions”

An article entitled “Automatic Excess Benefit Transactions under IRC 4958” appeared in the IRS 2004 Continuing Professional Education text. This article is significant since it unexpectedly announced a new interpretation of section 4958. For the first time, the IRS asserted that some transactions will be considered “automatic” excess benefit transactions resulting in intermediate sanctions regardless of the amount involved. Even if the amount involved in a transaction is insignificant, it still may result in intermediate sanctions. This is an important development, since it exposes virtually every pastor and lay church employee to intermediate sanctions that until now had been reserved for a few highly-paid charitable CEOs.

The IRS article laid down the following principles:

1. An economic benefit will be treated as compensation under section 4958 of the tax code (pertaining to intermediate sanctions) only if the exempt organization providing the benefit “clearly indicated its intent to treat the benefit as compensation for services when the benefit was paid.”

2. If the benefit is treated as compensation under section 4958, 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 intermediate sanctions).

3. If the exempt organization did not “clearly indicate its intent to treat the benefit as compensation for services when the benefit was paid,” then the benefit constitutes an “automatic” excess benefit resulting in intermediate sanctions, regardless of the amount of the benefit.

4. An exempt organization is treated as “clearly indicating its intent to treat an economic benefit as compensation for services” only if it “provided written substantiation that is contemporaneous with the transfer of the particular benefit.”

5. If the written contemporaneous substantiation requirement is not satisfied, the IRS will treat the economic benefit as an “automatic” excess benefit transaction without regard to whether: (1) the economic benefit is reasonable; (2) any other compensation the disqualified person may have received is reasonable, or (3) the aggregate of the economic benefit and any other compensation the disqualified person may have received is reasonable.

6. One method of providing written contemporaneous substantiation is by the timely reporting of economic benefits, either by the exempt organization or by the disqualified person. The exempt organization reports the economic benefit as compensation on Form W-2 or Form 1099 filed before the start of an IRS examination of either the exempt organization or the disqualified person for the year when the transaction occurred. The disqualified person reports the economic benefit as income on an original federal tax return (Form 1040), or on an amended federal tax return filed before the earlier of: (1) the start of an IRS examination of either the exempt organization or the disqualified person for the year when the transaction occurred, or (2) the first written documentation by the IRS of a potential excess benefit transaction involving either the exempt organization or the disqualified person.

7. Other written contemporaneous evidence may be used to demonstrate that the organization, through the appropriate decision-making body or an officer authorized to approve compensation, 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.

8. Reimbursements of expenses incurred by a disqualified person, paid by an exempt organization to the disqualified person, are disregarded under section 4958 if the expense reimbursements are made in compliance with an arrangement that qualifies as an “accountable plan.”

9. Reimbursements of expenses incurred by a disqualified person, paid by an exempt organization to the disqualified person under an arrangement that is a “nonaccountable plan” may be subject to intermediate sanctions under section 4958. If the exempt organization clearly indicates its intent to treat the reimbursements as compensation for services by satisfying the written contemporaneous substantiation requirements, the IRS will treat the reimbursements as compensation and add them to the disqualified person’s other compensation to determine whether, in the aggregate, all or any portion of the disqualified person’s compensation is unreasonable. However, if the organization does not satisfy the written contemporaneous substantiation requirements the IRS will treat reimbursements paid under a “nonaccountable plan” as “automatic” excess benefit transactions without regard to whether: (1) the reimbursements are reasonable; (2) any other compensation the disqualified persons may have received is reasonable; or (3) the aggregate of the reimbursements and any other compensation the disqualified person may have received is reasonable.

10. A disqualified person (or an organization manager) who is liable for tax imposed by section 4958 is required to file Form 4720 (Return of Certain Excise Taxes on Charities and Other Persons). Form 4720 must be filed annually reporting the excess benefit transactions that occurred which give rise to the tax liability under section 4958. If a disqualified person (or an organization manager) required to file Form 4720 did not file Form 4720 on or before the required due date, including extensions of time, a penalty of 5% of the amount of the correct tax under section 4958 would apply if the failure to file was not more than one month. For each additional month that the disqualified person (or the organization manager) did not file Form 4720, a penalty of 5% per month applies, but not exceeding 25% in total. If the disqualified person (or the organization manager) establishes that the failure to file was due to reasonable cause and not due to willful neglect, the penalty would not apply.

11. In examining economic benefits involving an exempt organization and its disqualified persons, the IRS will consider agreements, loans, and expense reimbursements or payments.

12. The IRS will consider agreements providing any type of economic benefits to any disqualified persons, to any member of their family and to any organizations in which the disqualified persons or any family members have an ownership interest. Agreements that may be reviewed include employment agreements, deferred compensation agreements, bonus agreements, retirement agreements, severance agreements, agreements for the purchase and sale of any goods or services .

13. The IRS will consider loan arrangements between the exempt organization and all disqualified persons, and review all loan documents. In particular, the IRS will determine whether payments were made in compliance with the loan documents.

14. The IRS will consider all expense reimbursements made by the exempt organization to all disqualified persons, and all expenses paid by the exempt organization to or on behalf of all disqualified persons.

The IRS article provides the following examples.

Example. From 2000 through 2004 a tax-exempt charity paid its President a salary of $50,000 per year. In 2004, it paid $35,000 for the President and the President’s spouse to take a vacation cruise around the world. The charity intended for this benefit to be additional compensation to the President, at the rate of $7,000 per year, for services the President performed from 2000 through 2004. During 2004, as to the $35,000 payment, the charity withheld additional federal income taxes and employment taxes from the President’s salary, reported the $35,000 payment as wages on its Form 941 for the appropriate calendar quarter and paid the appropriate income taxes and employment taxes as to the $35,000. The charity reported $85,000 as compensation on the President’s Form W-2 for 2004. The President reported $85,000 as compensation on Form 1040 for 2004. The IRS concluded that the charity’s reporting of the $35,000 benefit satisfied the written contemporaneous substantiation requirements, and therefore there were no “automatic” excess benefits. Further, “whether the President is treated as having received compensation of $57,000 per year from 2000 through 2004 or as having received $85,000 of compensation in 2004, since neither amount was unreasonable, none of the $35,000 paid for the vacation cruise constituted an excess benefit transaction under section 4958. See principle #2 above.

Example. Same facts as the previous example, except that the charity did not withhold additional federal income taxes or employment taxes from the President’s salary, did not report the $35,000 payment as wages on its Form 941 for the appropriate calendar quarter and did not pay the appropriate income taxes and employment taxes as to the $35,000. The charity reported only $50,000 as compensation on the President’s Form W-2 for 2004. The President reported only $50,000 as compensation on Form 1040 for 2004. In this example the charity did not “clearly indicate its intent to treat the benefit as compensation for services when the benefit was paid,” and therefore the benefit constitutes an “automatic” excess benefit resulting in intermediate sanctions, regardless of the amount of the benefit. See principle #3 above. So, even though the total amount would not have constituted an excess benefit had the charity reported it as taxable income, the fact that it did not makes the transaction an “automatic” excess benefit. This will result in (1) an excise tax of $8,750 (25% of $35,000); (2) an excise tax of $70,000 (200% of $35,000); (3) a penalty for failing to file Form 4270 (assuming the President failed to do so). If a disqualified person corrects an excess benefit transaction during the correction period, the 200% excise tax under section 4958 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 President can establish that in 2004, when the charity paid $35,000 on the President’s behalf, this 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 President cannot establish both of these requirements, the President would be liable for the 25% excise tax even though the President corrected the excess benefit transaction by paying $35,000 plus interest to the charity, and paid federal income tax on the $35,000 as additional compensation.

Example. A charity paid its President a salary of $50,000 per year. It adopted an expense reimbursement program that qualifies as an “accountable plan.” In 2004, the President traveled in connection with EO business and incurred travel expenses of $2,500. In 2004, the charity reimbursed the President $2,500 for these travel expenses. During 2004, the charity did not withhold and pay employment taxes on the $2,500 of expense reimbursements paid to the President. In addition, it did not report this $2,500 as wages on its Form 941 for the appropriate calendar quarter in 2004 and did not include this amount as wages on the President’s Form W-2. The charity reported $50,000 as compensation on the President’s Form W-2 for 2004. The President reported $50,000 as compensation on Form 1040 for 2004. The IRS concluded that “since the charity paid its President $2,500 under an accountable plan, the $2,500 is disregarded for purposes of section 4958.” This means that the reimbursements do not constitute an “automatic” excess benefit.

Example. Same facts as the previous example, except that in 2004 the President traveled on a personal matter and incurred travel expenses of $2,500. The charity reimbursed the President $2,500 for these travel expenses, but did not withhold and pay employment taxes or additional federal income taxes as to the $2,500 of expense reimbursements. In addition, the charity did not report this $2,500 as wages on its Form 941 for the appropriate calendar quarter in 2004 and did not include this amount as wages on the President’s Form W-2 for 2004. The charity reported only $50,000 as compensation on the President’s Form W-2 for 2004. The President reported $50,000 as compensation on Form 1040 for 2004. The $2,500 reimbursement was nonaccountable since the President failed to substantiate a business purpose. Neither the charity nor President “clearly indicated an intent to treat the benefit as compensation for services when the benefit was paid” since the charity did not report the $2,500 nonaccountable reimbursement as taxable income on Form 941 or Form W-2, and the President failed to report the amount as taxable income on Form 1040. As a result, the IRS will treat the reimbursement as an “automatic” excess benefit transaction without regard to whether (1) the reimbursement was reasonable; (2) any other compensation the disqualified persons may have received is reasonable; or (3) the aggregate of the reimbursements and any other compensation the disqualified person may have received is reasonable. So, even though the $2,500 reimbursement would not have constituted an excess benefit had the charity reported it as taxable income, the fact that it did not makes the transaction an “automatic” excess benefit. This will result in (1) an excise tax of $625 (25% of $2,500); (2) an excise tax of $5,000 (200% of $2,500); (3) a penalty for failing to file Form 4270 (assuming the President failed to do so). If a disqualified person corrects an excess benefit transaction during the correction period, the 200% excise tax under section 4958 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 President can establish that when the charity paid the $2,500 this 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 President cannot establish both of these requirements, the President would be liable for the 25% excise tax even though the President corrected the excess benefit transaction by paying $2,500 plus interest to the charity, and paid federal income tax on the $2,500 as additional compensation.

Richard R. Hammar is an attorney, CPA and author specializing in legal and tax issues for churches and clergy.

This content is designed to provide accurate and authoritative information in regard to the subject matter covered. It is sold with the understanding that the publisher is not engaged in rendering legal, accounting, or other professional service. If legal advice or other expert assistance is required, the services of a competent professional person should be sought. "From a Declaration of Principles jointly adopted by a Committee of the American Bar Association and a Committee of Publishers and Associations." Due to the nature of the U.S. legal system, laws and regulations constantly change. The editors encourage readers to carefully search the site for all content related to the topic of interest and consult qualified local counsel to verify the status of specific statutes, laws, regulations, and precedential court holdings.

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