Loans to Pastors

Article summary.
Many churches have made loans to a pastor. But few church leaders understand the legal and tax implications associated with such loans. For example, the nonprofit corporation laws of many states prohibit incorporated churches from making loans to an officer or director. Such law often will apply to senior pastors, since they typically are officers or directors of the church. Associate pastors also may be affected in some cases. Church leaders also need to be familiar with the tax implications of these loans. Most importantly, if a loan is “interest free” or at a “below market” rate of interest, then the pastor to whom the loan was made may realize taxable income from the transaction that must be properly reported by the church. No-interest or low-interest loans also may constitute prohibited “inurement” of the church’s assets to a private individual, thereby jeopardizing the church’s tax-exempt status. This feature article provides church leaders with the information they need to make informed decisions concerning loans to staff members.

Key point 6-07.10. Church board members may be personally liable, under state nonprofit corporation law, for loans they authorize for any officer or director of the church.

Has your church ever made a loan to a pastor? If so, were the legal and tax implications of the transaction carefully considered beforehand? Unfortunately, church leaders who authorize such loans seldom have a clear understanding of the consequences. This article was written to provide church leaders with relevant and up-to-date information that will assist them in making informed decisions regarding loans to staff members. The article begins by reviewing why these loans are made, and then addresses the legal and tax implications. Several examples help to communicate the key principles.

Churches make loans to pastors for different reasons. The following examples illustrate some common scenarios.

Example 1. Pastor Bob has lived in a church-owned parsonage for five years, and now would like to purchase a home but cannot afford the down payment. The church board votes to loan Pastor Bob $15,000 at no interest to cover the cost of the down payment. While the “loan” is reflected in the minutes of the board, no promissory note is signed by Pastor Bob and there is no specified term for repayment. The board informs Pastor Bob that the loan will be payable at such time as he ceases to be pastor of the church.

Example 2. Pastor Dave has rented a home for several years, and now would like to purchase a home but cannot afford the down payment. The church board votes to loan Pastor Dave $20,000 to cover the cost of the down payment. Pastor Dave signs a promissory note in the amount of $15,000 at 8% interest payable on demand.

Example 3. Same facts as the previous example except that Pastor Dave signs a promissory note in the amount of $15,000 at 8% interest payable over a five-year term.

Example 4. Pastor Donna is hired as the pastor of a church in a high-cost community in which the price of housing is high. To assist Pastor Donna in purchasing a home, the church board agrees to loan her $25,000 to cover the cost of a down payment on a home. Pastor Donna signs a promissory note in the amount of $25,000 at 3% interest payable on demand.

Example 5. A church hires Pastor Erik as its new youth pastor. To assist Pastor Erik in purchasing a home, the church board agrees to loan him $7,500 at no interest to cover the cost of the down payment on a home. Pastor Erik agrees to pay the loan back when he leaves the church, but no promissory note is signed.

Example 6. Same facts as the previous example except that Pastor Erik signs a promissory note in the amount of $7,500 at 8% interest payable over a ten-year term.

Example 7. A church loans its pastor $10,000 to assist with the payment of college tuition for the pastor’s daughter. A promissory note is signed by the pastor in the amount of $10,000, at 4% interest and payable over a 5-year term.

Example 8. A music minister incurs substantial and unexpected expenses in replacing the roof on her home. The church loans her $5,000 to cover the project. No promissory note is signed, and no interest is charged. The minister is asked to “pay the loan back as you are able.”

This article will help you to evaluate the legal and tax implications of loans like those described in these examples.

There are two legal issues that need to be addressed: (1) is the “loan” a valid and enforceable obligation; and (2) is the loan legally permissible under state nonprofit corporation law. These two issues will be considered separately.

(1) is the loan legally enforceable

When a church makes a “loan” to a pastor, it is important to know whether the “loan” is legally enforceable by the lender. In some cases, loans to pastors are not enforceable because no promissory note has been signed. A promissory note is a legal document that sets forth the terms and conditions of a loan. Generally, a promissory note will contain the amount of the loan, the interest rate, the length (“term”) of the loan, a promise to pay, and the borrower’s signature. In many states, promissory notes above a specified amount must be in writing to be legally enforceable, and so an oral commitment by a pastor to repay a church “loan” may not be enforceable. Of course, the fact that the commitment is not legally enforceable does not affect or diminish the moral obligation to repay.

Even if the loan is not required to be in writing under state law, a church’s failure to reduce the commitment to writing may make it unenforceable because of the difficulty encountered in proving the actual terms of the oral commitment. In examples 1, 5, and 8 (above) no promissory note was signed by the pastor. As a result, the obligation of the pastor in each example may be legally unenforceable.

Article 3 of the Uniform Commercial Code, which has been enacted in 49 states and governs “negotiable instruments.” A negotiable instrument can be “negotiated” or transferred to another person and become legally enforceable by that person. A promissory note that contains the terms and conditions of a loan to a pastor does not need to comply with the definition of a negotiable instrument. Failure to comply with the definition of a negotiable instrument simply means that only the church can enforce the pastor’s legal obligation. The church cannot “negotiate” or transfer its rights under the note to another person or institution. The Uniform Commercial Code defines a promissory note as

an unconditional promise or promise or order may contain (i) an undertaking or power to give, maintain, or protect collateral to secure payment, (ii) an authorization or power to the holder to confess judgment or realize on or dispose of collateral, or (iii) a waiver of the benefit of any law intended for the advantage or protection of an obligor.

Again, this definition is relevant only if a church wants to be able to negotiate or transfer its right of payment under the note to other persons or institutions. In most cases, this is not an important objective.

There are many forms of promissory note. The two most common are “demand” notes (the loan is payable at the demand of the lender), or “term” notes (the loan is payable in installments over a specified term). In addition, notes may be secured or unsecured. A secured note refers to a mortgage or other security agreement in which the borrower gives the lender a legal right to sell specified property (“collateral”) of the borrower in the event of nonpayment. An unsecured note does not give the lender any legal right to the borrower’s property in the event of nonpayment. Few churches require their pastor to sign a secured note. In most cases, the church is satisfied that the pastor will honor the moral obligation to repay the debt. As a practical matter, secured notes generally are secured by an interest in the borrower’s home or car. Since many pastors already have a mortgage on their home and a security interest in their car, there is no property that can serve as collateral for a church loan.

A sample “demand” note and a sample “term” note are reproduced in this article. Note that these forms are simple, generic, unsecured, and non-negotiable. They are for illustrative purposes only.

Promissory Note (term note—not negotiable)

Principal amount: $10,000

Date: June 1, 2002

Term: 5 years

FOR VALUE RECEIVED the undersigned promises to pay to the order of First Church, of Anytown, New York, the principal sum of TEN THOUSAND DOLLARS ($10,000) together with interest thereon from date at the rate of seven percent (7%) per annum until maturity, said principal and interest being payable monthly on the first day of each and every month beginning on the first day of July, 2002 in monthly installments of ONE HUNDRED AND NINETY EIGHT DOLLARS ($198) and continuing thereafter until the full amount of this note and accrued interest shall be fully paid. All payments shall be first applied to the accrued interest and the balance to the principal. The undersigned reserves the right to pre-pay this note in whole or in part without penalty.

Upon default in the payment of principal and/or interest when due, the whole sum of principal and interest remaining unpaid shall, at the option of the holder, become immediately due and payable and it shall accrue interest at the highest rate allowable by law from the date of default. Default shall include, but not be limited to non-payment of any respective installment within ten (10) days from the due date set out herein.

_______________________________

Pastor John Doe

_______________________________

Witness

_______________________________

Witness

Promissory Note (demand note—not negotiable)

Principal amount: $10,000

Date: June 1, 2002

Term: on demand

On demand, the undersigned, for value received, promises to pay to the order of First Church, of Anytown, New York, the principal sum of TEN THOUSAND DOLLARS ($10,000) together with interest thereon from the date hereof until paid at the rate of seven percent (7%) per annum.

_______________________________

Pastor John Doe

_______________________________

Witness

_______________________________

Witness

(2) does the loan violate state nonprofit corporation law

The nonprofit corporation laws of most states prohibit loans to directors and officers. Directors who vote in favor of such loans can be liable for them in the event that the loan is unauthorized or otherwise impermissible. Now, for the first time, a table in this newsletter summarizes the relevant provisions of the nonprofit corporation laws of all 50 states so that church leaders can quickly and easily see that legal status of such loans in their state.

Before using the table, please note the following considerations:

• This table refers to the laws of all 50 states as of the time of publication. Note that many of these laws were enacted or amended in the past year or two, so church leaders should not rely on old research in evaluating the legality of loans made to officers or directors.

• A few states no longer have nonprofit corporation laws. Instead, they have enacted a “general” corporation law that governs both for-profit and nonprofit corporations.

• Some states have both a “general” nonprofit corporation law and a special religious corporations law. In some of these states, the provisions of the general nonprofit corporation law apply to churches that are incorporated under the religious corporations law, but in other states this is not true. The table in this newsletter only addresses the legality of loans to officers and directors under the general nonprofit corporation laws of the 50 states. Special religious corporations laws are often much older laws than the more modern “general” nonprofit corporation laws, and contain very little detail concerning governance and administration, and no prohibition on loans to officers or directors. If your church is incorporated under a “special” religious corporations law, then (1) determine if such corporations are subject to the provisions of the general nonprofit corporation law (this is often the case), and (2) determine if the special religious corporations law contains a specific prohibition against loans to officers or directors (most do not). If your church is incorporated under a special religious corporations law, we recommend that you retain an attorney to answer these questions. For the vast majority of churches that are incorporated under a general nonprofit corporation law, the table in this newsletter will be fully applicable.

• Churches cannot incorporate in either Virginia or West Virginia. While both states have nonprofit corporation laws that prohibit loans to directors and officers, these prohibitions do not apply to church officers and directors. However, some forms of religious organizations are permitted to incorporate in these states, and so the prohibition on loans to officers and directors may apply to them.

• The fact that a state nonprofit corporation law has no specific prohibition of loans to officers of directors does not necessarily mean that such loans cannot be challenged on other legal grounds. For example, it is possible that such a loan may violate board members’ “fiduciary duties” to the corporation. As we will see later in this article, such loans may create adverse tax consequences.

• State laws are subject to change, and so this table should not be relied upon without the advice of an attorney familiar with local law.

Loans to Officers and Directors

A review of the general nonprofit corporation laws of all 50 states

StateApplicable law

There are three tax issues associated with church loans to ministers: (1) does the loan result in taxable income being realized by the minister; (2) does the loan constitute “inurement” of the church’s resources to a private individual in violation of the church’s tax-exempt status; and (3) what if the minister fails to pay back the loan? These issues will be considered separately.

Churches often make low-interest or no-interest loans (both are referred to as “below-market loans”) to ministers and lay employees. These loans may result in additional compensation to the recipient under the following rules:

gift and demand loans

If a church makes a gift or demand loan at a below-market interest rate, it generally must report as “interest income” any “forgone interest” from that loan. For any period, forgone interest is: (1) The amount of interest that would be payable for that period if interest accrued on the loan at the applicable federal rate and was payable annually on December 31, minus (2) any interest actually payable on the loan for the period. Applicable federal rates are published by the IRS each month in the Internal Revenue Bulletin. Each copy of the weekly Internal Revenue Bulletin is available online at the IRS website (www.irs.gov). Simply select “tax info for business” at the bottom of the start screen, and then scroll down to the bottom of the options until you see the heading “Internal Revenue Bulletins.” You also can call the IRS to get the monthly interest rate.

A gift loan is any below-market loan where the “forgone interest” is in the nature of a gift. A demand loan is a loan payable in full at any time upon demand by the lender. A demand loan is a below-market loan if no interest is charged or if interest is charged at a rate below the applicable federal rate.

A demand loan or gift loan that is a below-market loan is generally treated as an arm’s-length transaction in which the lender is treated as having made: (1) A loan to the borrower in exchange for a note that requires the payment of interest at the applicable federal rate, and (2) an “additional payment” to the borrower in an amount equal to the “forgone interest.” The lender’s additional payment to the borrower is treated as a gift, pay for services, or other payment, depending on the nature of the transaction. The borrower may have to report this payment as taxable income, depending on its classification. These transfers are considered to occur annually, generally on December 31.

term loans

A term loan is any loan that is not a demand loan. A term loan is a below-market loan if the amount of the loan is more than the present value of all payments due under the loan. A lender who makes a below-market term loan other than a gift loan is treated as transferring an additional lump-sum cash payment to the borrower on the date the loan is made. The amount of this payment is the amount of the loan minus the present value, at the applicable federal rate, of all payments due under the loan. An equal amount is treated as original issue discount (OID). The lender must report the annual part of the OID as interest income. The borrower may be able to deduct the OID as interest expense.

exceptions

1. Loans of less than $10,000. The rules for below-market loans do not apply to any day on which the total outstanding amount of loans between the borrower and lender is $10,000 or less. This exception applies only to (1) gift loans between individuals if the gift loan is not directly used to buy or carry income-producing assets, and (2) pay-related loans if the avoidance of federal tax is not a principal purpose of the interest arrangement. This exception does not apply to a term loan that previously has been subject to the below-market loan rules. Those rules will continue to apply even if the outstanding balance is reduced to $10,000 or less.

2. Loans with no tax effect. Also exempted from the below-market loan rules are loans for which the interest arrangement can be shown to have no significant effect on the federal tax liability of the lender or the borrower. Some of the facts the IRS considers in making such a decision include (1) the amount of the loan, (2) the cost of complying with the below-market loan rules, if they were to apply, and (3) any reasons other than taxes for structuring the transaction as a below-market loan. This exception may apply in some cases to ministers. Consider the following example.

Example 9. Pastor Gary lived in the church parsonage for many years, and in 2000 purchased his own home. To assist in making the down payment on a new home, the church board loaned Pastor Gary $7,500 in 2000. The loan is a demand loan, at no interest. Neither the church nor Pastor Gary reported any foregone interest ($7,500 x the federal interest rate) for 2001. Was this correct? Yes, since the amount of the loan was for less than $10,000. This assumes that tax avoidance was not the principal purpose of the arrangement.

Example 10. Same facts as example 9, except that the amount of the loan was $20,000. The IRS audits Pastor Gary’s 2001 tax return and insists that he should have reported the foregone interest on the loan for that year at the applicable federal interest rate. Assuming that this rate was 8% for all of 2001, Pastor Gary would have to report an additional $1,600 of taxable income for 2001 ($20,000 x 8%). However, Pastor Gary argues that the no-interest loan had no significant effect on his federal tax liability. He points out that even if the church had charged him 8% interest, this amount could have been excluded from his taxable income as a housing allowance since it was an expense of home ownership.

Example 11. Same facts as example 9, except that the amount of the church loan was $100,000. Pastor Gary argues that the no-interest loan had no significant effect on his federal tax liability. It is unlikely that this argument will succeed, given the amount of the loan. As a result, it is likely that Pastor Gary will have to pay taxes on an additional $8,000 of income for 2001 ($100,000 x 8%).

3. Loans made by charitable organizations. The income tax regulations exempt loans made by a charitable organization, if the primary purpose of the loan is to accomplish religious, charitable, or educational purposes. This exception ordinarily will not apply to below-market interest loans made by churches to ministers or lay employees, since the purpose of such loans is to assist or compensate the recipient rather than to fulfill specific exempt purposes. Treasury Regulation 1.7872-5T(b)(11).

4. Employee relocation loans. The regulations further specify that “[i]n the case of a compensation-related loan to an employee, where such loan is secured by a mortgage on the new principal residence … of the employee, acquired in connection with the transfer of that employee to a new principal place of work … the loan will be exempt from [tax] if the following conditions are satisfied: (a) The loan is a demand loan or is a term loan the benefits of the interest arrangements of which are not transferable by the employee and are conditioned on the future performance of substantial services by the employee; (b) the employee certifies to the employer that the employee reasonably expects to be entitled to and will itemize deductions for each year the loan is outstanding; and (c) the loan agreement requires that the loan proceeds be used only to purchase the new principal residence of the employee.” Treasury Regulation 1.7872-5T(c)(1).

Example 12. A church hires Pastor Carol as its music minister. Pastor Carol will be moving from another state, and would like to purchase a home in her new community. The church board would like to assist her in making the down payment on a new home, and loans her $25,000 at no interest, payable on demand. The church can help Pastor Carol qualify for the “employee relocation” exception to the below-market loan rules by having Pastor Carol sign a promissory note in the amount of $25,000 that is secured by a mortgage on the new home, and, by having Pastor Carol sign a loan agreement containing the following provisions: (1) the benefits of the interest arrangement is not transferable by Pastor Carol; (2) the benefits of the interest arrangement are conditioned on the future performance of substantial services by Pastor Carol; (3) Pastor Carol certifies that she reasonably expects to be entitled to and will itemize deductions for each year the loan is outstanding; and (4) the loan proceeds will be used only to purchase the new principal residence.

(2) the tax consequences of loan forgiveness

Many churches have “forgiven” the loans they have made to a staff pastor. Consider the following example.

Example 13. A church hires Pastor Chris as its new youth pastor in 1999. To assist Pastor Chris in purchasing a home, the church board agrees to loan him $10,000 at no interest to cover the cost of the down payment on a home. Pastor Chris signs a 5-year promissory note, and makes monthly payments until he resigns his position in 2001 after two years and moves to another state. The church treasurer writes Pastor Chris on three occasions, asking him why he has stopped making his monthly payments. He never receives a reply. In 2002, the church board votes to “forgive” the balance of $6,000.

What should a church treasurer do under these circumstances? The tax code states that the forgiveness of debt ordinarily represents taxable income to the debtor. IRC 61(a)(12). As a result, if a church makes a loan to a minister or other staff member and the debt is later forgiven by the church, the church should report the forgiven debt as income. Here are the rules to follow, using the same facts as in the example:

• If the church has not yet issued a W-2 or 1099 to Pastor Chris for his last year of employment, then report the forgiven debt on the W-2 or 1099.

• If the church already has issued a W-2 or 1099 to Pastor Chris for the last year of employment then there are two options:

(1) Issue a corrected W-2 or 1099, reporting the full amount of the forgiven debt as additional compensation for the last year of employment. A corrected W-2 is prepared on Form W-2c. Be sure to note the year of the Form W-2 that is being corrected. There is no separate form for a corrected 1099—simply fill out a new 1099 and check the box at the top of the form indicating that it is a “corrected” version. This approach correctly restates compensation for Pastor Chris’s last year of employment.

(2) Issue a 1099 reporting the full amount of the forgiven debt in the current year (2002). It is appropriate to report the forgiven debt as income in the year the debt is actually forgiven rather than restating Pastor Chris’s compensation for his last year of employment, since taxable income does not actually occur until the year in which the debt is forgiven (the current year).

Example 14. A minister failed to report the discharge of an educational loan as income on his tax return. The Tax Court ruled that the forgiven loan balance should have been reported as income. The Court also upheld an IRS assessment of a negligence penalty against the minister. Parker v. Commissioner, 65 T.C.M. 1740 (1993).