Loans to Pastors

Legal and tax implications.


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.

Church Officers, Directors, and Trustees

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.

Background

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.

Legal issues

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.

Key point. If a church’s loan to a pastor is not reflected in a promissory note, the pastor may argue that the transfer of funds was not a loan at all, but a gift. Such a defense creates a risk to the pastor, because it amounts to an acknowledgment that income was received that was not reported to the IRS. Churches ordinarily cannot make personal “gifts” to pastors without reporting the gifts as taxable income.

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

AL“No loans shall be made by a corporation to its directors or officers. Any director or officer who assents to or participates in the making of any such loan shall be liable to the corporation for the amount of such loan until the repayment thereof.” Nonprofit Corporation Act § 10-3A-45 (1984)
AK“A corporation may not make loans to its directors or officers. A director or officer who assents to or participates in the making of such a loan shall be liable to the corporation for the amount of the loan until its repayment.” Nonprofit Corporation Act § 10.20.141 (1968)
AZ“A corporation shall not make any loan, directly or indirectly, to any of its officers or directors or to any person, corporation or other form of organization in which such officer or director is a member, director or officer or in which such officer or director has any interest, direct or indirect, financial or otherwise, except when a full and complete disclosure of the relationship is made at a regularly called meeting of the board of directors of the corporation, entered upon the minutes, and voted on by secret ballot with the officer or director making such disclosure refraining from voting on the motion.” Nonprofit Corporation Act § 10-2263(C) (1996)
AR“(a) No loans shall be made by a corporation to its directors or officers. (b) The directors of a corporation who vote for or assent to the making of a loan to a director or officer, and any officers participating in the making of the loan shall be jointly and severally liable to the corporation for the amount of the loan until repayment thereof.” Nonprofit Corporation Act § 4-28-220 (1963)
CA“A director shall perform the duties of a director, including duties as a member of any committee of the board upon which the director may serve, in good faith, in a manner such director believes to be in the best interests of the corporation and with such care, including reasonable inquiry, as is appropriate under the circumstances …. The provisions of this section … shall govern any action or omission of a director in regard to … any loan of money or property to or guaranty of the obligation of any director or officer. No obligation, otherwise valid, shall be voidable merely because directors who benefited by a board resolution to … make such loan or guaranty participated in making such board resolution.” Nonprofit Corporation Law § 9241 (1980)
CO“Except as this article is specifically in conflict therewith, the provisions of the nonprofit corporation code shall be applicable to this article .” Religious and Benevolent Corporations § 7-52-106“No loans shall be made by a corporation to its directors or officers. Any director or officer who assents to or participates in the making of any such loan shall be liable to the corporation for the amount of such loan until the repayment thereof.” Nonprofit Corporation Code § 7-128-501 (1998)
CN“Directors who vote for or assent to the making of a loan to an officer or to a director of a corporation, or any officer or loan, which loan is neither made in the usual course of the corporation’s affairs nor made primarily for a legitimate purpose of the corporation, shall be jointly and severally liable to the corporation for the amount of such loan until the repayment thereof.” Revised Nonstock Corporation Act § 33-1106 (1997)
DE“Any corporation may lend money to, or guarantee any obligation of, or otherwise assist any officer or other employee of the corporation … including any officer or employee who is a director of the corporation … whenever, in the judgment of the directors, such loan, guaranty or assistance may reasonably be expected to benefit the corporation. The loan, guaranty or other assistance may be with or without interest, and may be unsecured, or secured in such manner as the board of directors shall approve … .” General Corporation Law § 143 (1953)
DC“No loans shall be made by a corporation to its directors or officers. The directors of a corporation who vote for or assent to the making of a loan to a director or officer of the corporation, and any officer or officers participating in the making of such a loan, shall be jointly and severally liable to the corporation for the amount of such loan until the repayment thereof.” Code § 29-301.28 (1962)
FL“Loans, other than through the purchase of bonds, debentures, or similar obligations of the type customarily sold in public offerings, or through ordinary deposit of funds in a bank, may not be made by a corporation to its directors or officers, or to any other corporation, firm, association, or other entity in which one or more of its directors or officers is a director or officer or holds a substantial financial interest, except a loan by one corporation which is exempt from federal income taxation under section 501(c)(3) of the Internal Revenue Code of 1986, as amended, to another corporation which is exempt from federal income taxation under section 501(c)(3) of the Internal Revenue Code of 1986, as amended. A loan made in violation of this section is a violation of the duty to the corporation of the directors or officers authorizing it or participating in it, but the obligation of the borrower with respect to the loan shall not be affected thereby.” Not for Profit Corporation Act § 617.0833 (1993)
GANo specific prohibition of loans to officers or directors. However, this section does prohibit specified “conflicting interest” transactions by a nonprofit corporation and an officer or director if certain conditions are met, and it is possible that a loan by a nonprofit corporation to an officer or director would qualify as a conflicting interest transaction. Nonprofit Corporation Code § 14-3-860 (1991)
HI“No loans shall be made by a corporation to its directors or officers. Any director or officer who assents to or participates in the making of a loan shall be liable to the corporation for the amount of the loan until it is repaid. For the purposes of this section, any director who votes against the making of a loan shall be deemed not to have assented to or participated in the making of the loan.” Nonprofit Corporation Act § 415B-70 (1987)
ID“(1) Except with regard to loan or guarantee programs available to all members, a corporation may not lend money to or guarantee the obligation of a director or officer of the corporation, provided that a cooperative corporation may lend money to or guarantee the obligation of a director or officer with regard to loan or guarantee programs available to all members.”(2) The fact that a loan or guarantee is made in violation of this section does not affect the borrower’s liability on the loan.” Nonprofit Corporation Code § 30-3-82 (1993)
IL“[N]o loan shall be made by a corporation to a director or officer except that a loan may be made to a director or officer who is employed by the corporation if authorized by a majority of the non-employed directors and either (a) in the case of a corporation organized for and holding property for any charitable, religious, eleemosynary, benevolent, educational or similar purpose, the purpose of such loan is to provide financing for the principal residence of the employed director or officer upon receipt of adequate collateral consisting of marketable real estate or securities readily capable of valuation or (b) the loan is otherwise in furtherance of the purposes of the corporation and in the ordinary course of its affairs. The directors of a corporation who vote for or assent to the making of a loan to any non-employed director or non-employed officer of the corporation, or otherwise prohibited by this section, and any other person knowingly participating in the making of such loan, shall be jointly and severally liable to the corporation for the amount of such loan until the repayment thereof.” General Not for Profit Corporation Act § 105/108.80 (1987)
IN“(a) A corporation may not: (1) lend money to; or (2) guarantee the obligation of; a director or an officer of the corporation. (b) A loan or guaranty that is made in violation of this section does not affect the borrower’s liability on the loan.” Nonprofit Corporations Act § 23-17-13-3 (1991)
IA“No loans shall be made by a corporation to its directors or officers. Any director or officer who assents to or participates in the making of any such loan shall be liable to the corporation for the amount of such loan until the repayment thereof.” Nonprofit Corporation Act § 504A.27 (1965)
KS“Any corporation may lend money to, or guarantee any obligation of, or otherwise assist any officer or other employee of the corporation or of its subsidiary, including any officer or employee who is a director of the corporation or its subsidiary, whenever, in the judgment of the directors, such loan, guaranty or assistance may reasonably be expected to benefit the corporation. The loan, guaranty or other assistance may be with or without interest, and may be unsecured, or secured in such manner as the board of directors shall approve, including, without limitation, a pledge of shares of stock of the corporation. Nothing contained in this section shall be deemed to deny, limit or restrict the powers of guaranty or warranty of any corporation at common law or under any statute.” General Corporations Code § 17-6363 (1972)
KY“No loans shall be made by a corporation to its directors or officers. Any director or officer who assents to or participates in the making of any such loan shall be liable to the corporation for the amount of such loan until the repayment thereof.” Nonprofit Corporations Act § 273.241 (1968)
LANo specific prohibition of loans to officers or directors. However, this section provides that “no transaction between a corporation and one or more of its directors or officers … shall be void or voidable solely for this reason … if: (1) The material facts as to his interest and as to the transaction were disclosed or known to the board of directors … and the board … in good faith authorized the transaction by a vote sufficient for such purpose without counting the vote of the interested director or directors; or (2) The material facts as to his interest and as to the transaction were disclosed or known to the members entitled to vote thereon, and the contract or transaction was approved in good faith by vote of the members; or (3) The contract or transaction was fair as to the corporation as of the time it was authorized, approved or ratified by the board of directors, committee, or members.” Nonprofit Corporation Law § 228 (1969)
ME“No loans shall be made by a corporation to its directors or officers. Any director or officer who assents to or participates in the making of any such loan shall be liable to the corporation for the amount of such loan until the repayment thereof.” Nonprofit Corporations Act § 712 (1977)
MD“A corporation may lend money to, guarantee an obligation of, or otherwise assist an officer or other employee of the corporation … if the loan, guarantee, or assistance … in the judgment of the directors, reasonably may be expected to benefit the corporation …. The loan, guarantee, or other assistance may be: (1) with or without interest; (2) unsecured; or (3) secured in any manner that the board of directors approves ….” General Corporations Law § 2-416 (1976)
MANo specific prohibition of loans to officers or directors. However, this section provides, “A director, officer or incorporator of a corporation shall perform his duties as such, including, in the case of a director, his duties as a member of a committee of the board upon which he may serve, in good faith and in a manner he reasonably believes to be in the best interests of the corporation, and with such care as an ordinarily prudent person in a like position with respect to a similar corporation organized under this chapter would use under similar circumstances.” Gen. Laws Title XXII, Ch. 180, § 6C (1989)
MI“Unless otherwise prohibited by law, a corporation may lend money to, or guarantee an obligation of, or otherwise assist an officer or employee of the corporation or of its subsidiary, including an officer or employee who is a director of the corporation or its subsidiary, when, in the judgment of the board, the loan, guaranty, or assistance may reasonably be expected to benefit the corporation. The loan, guaranty, or assistance may be with or without interest, and may be unsecured, or secured in such manner as the board approves. Nothing in this section shall be deemed to deny, limit, or restrict the powers of guaranty or warranty of a corporation at common law or under any statute.” Nonprofit Corporation Act § 450.2548 (1983)
MN“A corporation may not lend money to or guarantee the obligation of a director, officer, or employee of the corporation or a related organization, or of the spouse, parents, children and spouses of children, brothers and sisters or spouses of brothers and sisters of the director, officer, or employee, unless the loan or guarantee may reasonably be expected, in the judgment of the board, to benefit the corporation. If a loan or guarantee is made in violation of this subdivision, the borrower’s liability on the loan is not affected. The officers and directors who make a loan in violation of this subdivision or assent to it are jointly and severally liable for its repayment …. A loan, guaranty, surety contract, or other financial assistance … may be with or without interest and may be unsecured or secured …. This section does not grant authority to act as a bank or to carry on the business of banking.” Nonprofit Corporation Act § 317A.501 (1989)
MS“(1) A corporation may not lend money to or guarantee the obligation of a director or officer of the corporation. (2) The fact that a loan or guarantee is made in violation of this section does not affect the borrower’s liability on the loan.” Nonprofit Corporation Act § 79-11-282 (1988)
MO“A corporation which qualifies for an exemption from federal income tax … may lend money to or guarantee the obligation of a director or officer of the corporation, provided that such loan does not exceed the lesser of twenty-five percent of the total assets of the corporation or two hundred and fifty thousand dollars.” Not for Profit Corporation Law § 355.421 (1995)
MT“(1) A corporation may not lend money to or guarantee the obligation of a director or officer of the corporation. (2) The fact that a loan or guaranty is made in violation of this section does not affect the borrower’s liability on the loan.” Nonprofit Corporation Act § 35-2-435 (1991)
NE“(a) A corporation may not lend money to or guaranty the obligation of a director or officer of the corporation. (b) The fact that a loan or guaranty is made in violation of this section does not affect the borrower’s liability on the loan.” Nonprofit Corporation Act § 21-1988 (1996)
NVNo specific prohibition of loans to officers or directors. However, this section provides, “No contract or other transaction between a corporation and one or more of its directors or officers … is void or voidable solely for this reason or solely because any such director or officer is present at the meeting of the board of directors or a committee thereof which authorizes or approves the contract or transaction, or because the vote or votes of common or interested directors are counted for such purpose, if the circumstances specified in any of the following paragraphs exist … (d) The contract or transaction is fair as to the corporation at the time it is authorized or approved.” Rev. Stat. § 82.226 (1991)
NHNo specific prohibition of loans to officers or directors, although such loans may be challenged on the ground that they violate the fiduciary duties of a board who authorizes them.
NJ“A corporation may lend money to, or guarantee any obligation of, or otherwise assist, any officer or other employee of the corporation or of any subsidiary, whenever, in the judgment of the board, the loan, guarantee or assistance may reasonably be expected to benefit the corporation, except that a corporation shall not lend money to, guarantee any obligation of, or otherwise assist, any officer or other employee who is also a trustee of the corporation unless the loan, guarantee or assistance is authorized by the certificate of incorporation or bylaws and then only when authorized by at least two-thirds of the entire board, with the vote of the interested trustee not counted. The loan, guarantee or other assistance may be made with or without interest, and may be unsecured or secured in a manner as the board shall approve, and may be made upon other terms and conditions as the board may determine.” Nonprofit Corporation Act § 15A:6-11 (1983)
NM“Any director or officer who assents to or participates in the making of any loan to a director or officer shall be personally liable to the corporation for the amount of the loan until the repayment thereof.” Nonprofit Corporation Act § 53-8-29 (1975)
NYThe Religious Corporations Law does not specifically prohibit loans to officers or directors. However, the Nonprofit Corporation Act provides, “No loans, other than through the purchase of bonds, debentures, or similar obligations of the type customarily sold in public offerings, or through ordinary deposit of funds in a bank, shall be made by a corporation to its directors or officers, or to any other corporation, firm, association or other entity in which one or more of its directors or officers are directors or officers or hold a substantial financial interest, except a loan by one type B corporation to another type B corporation. A loan made in violation of this section shall be a violation of the duty to the corporation of the directors or officers authorizing it or participating in it, but the obligation of the borrower with respect to the loan shall not be affected thereby.” Not-for-Profit Corporation Law § 716 (1971) Note: A New York court has observed that “all of the provisions of the Not-For-Profit Corporation Law are applicable to church organizations except in instances where the Religious Corporations Law contains a provision in direct conflict with the Not-For- Profit Corporation Law.” City of New York v. Committee to Preserve St. Bartholomew’s Church, Inc., 445 N.Y.S.2d 975 (1972).
NC“No loan, guaranty, or other form of security shall be made or provided by a corporation to or for the benefit of its directors or officers, except that loans, guaranties, or other forms of security may be made to full-time employees of the corporation who are also directors or officers by action of its board of directors in accordance with section 55A-8-312(a)(1) [which specifies that a “conflict of interest transaction is not voidable by the corporation solely because of the director’s interest in the transaction if … the material facts of the transaction and the director’s interest were disclosed or known to the board of directors or a committee of the board and the board or committee authorized, approved, or ratified the transaction.” Nonprofit Corporation Act § 55A-8-32 (1994)
ND“2. A corporation may not lend money to or guarantee the obligation of a director or officer of the corporation or a related organization, or of the spouse, parents, children and spouses of children, brothers and sisters or spouses of brothers and sisters of the director or officer.
a. If a loan or guarantee is made in violation of this section, the borrower’s liability on the loan is not affected.
b. The directors of a corporation who vote for or assent to the making of a loan to a director or officer of the corporation, or who vote for or assent to the guarantee of the obligation of a director or officer of the corporation, and any officer participating in the making of such loan or guarantee shall be jointly and severally liable to the corporation for the amount of the loan until its repayment.
c. This subsection does not prohibit an advance of money for expenses ….
3. A loan, guaranty, surety contract, or other financial assistance under subsection 1 or 2 may be with or without interest and may be unsecured or secured.
4. This section does not grant authority to act as a bank or to carry on the business of banking.” Code § 10-33-82 (1997)
OHNo specific prohibition of loans to officers or directors. However, this section provides that unless otherwise provided in the articles of incorporation a transaction between a corporation and an officer or director is not void or voidable if (1) the director’s interests as to the transaction are disclosed or are known to the directors or members and the directors or members authorize the transaction by majority vote; or (2) the transaction is fair as to the corporation as of the time it is authorized or approved by the directors or the members. Nonprofit Corporation Law § 1702.301 (1988)
OK“The provisions of the Oklahoma General Corporation Act shall be applicable to every corporation, whether profit or not for profit … existing as of the effective date of this act or thereafter formed … except to the extent that special provisions concerning any such corporation conflict with the provisions of the Oklahoma General Corporation Act, in which case such special provisions shall govern.” General Corporation Act § 1002 (1986)“Any corporation may lend money to, or guarantee any obligation of, or otherwise assist any officer or other employee of the corporation or of its subsidiary, including any officer or employee who is a director of the corporation or its subsidiary whenever, in the judgment of the directors, such loan, guaranty or assistance may reasonably be expected to benefit the corporation. The loan, guaranty or other assistance may be with or without interest, and may be unsecured, or secured in such manner as the board of directors shall approve, including, without limitation, a pledge of shares of stock of the corporation. Nothing contained in this section shall be construed to deny, limit or restrict the powers of guaranty or warranty of any corporation at common law or under any statute.” General Corporation Act § 1029 (1986)
OR“Religious corporations may not make a loan, guarantee an obligation or modify a preexisting loan or guarantee to or for the benefit of a director or officer of the corporation, except as stated in this section. Unless prohibited by its articles or bylaws, a … religious corporation may make a loan, guarantee an obligation or modify a preexisting loan or guarantee to or for the benefit of a director or officer as part of a recruitment package, for a total period not to exceed three years, provided that: (a) Approval of the loan, guarantee or modification is obtained in the manner provided in section 65.361(2) and (5) [by vote of the board of directors if the material facts of the transaction and the director’s interest are disclosed or known to the board of directors]; (b) notice of the loan, guarantee or modification is given to the members of the corporation [in writing before the notice of the next meeting of members]; and (c) twenty or more days before the loan, guarantee or modification is to become binding on the corporation, written notice has been given to the Attorney General of the proposed recruitment package for the director or officer, including identification of the amount and character of all items of compensation and a separate statement of the amount and terms of any such loan, guarantee or modification.” Rev. Stat. § 65.364 (1989)
PANo specific prohibition of loans to officers or directors, although such loans may be challenged on the ground that they violate the fiduciary duties of a board who authorizes them.
RI“No loans shall be made by a corporation to its directors. Any director who assents to or participates in the making of any loan is liable to the corporation for the amount of loan until its repayment.” Nonprofit Corporation Act § 7-6-32 (1984)
SC“A religious corporation may not directly or indirectly lend money to or guarantee the obligation of a director or officer of the corporation.” Nonprofit Corporation Act § 33-31-832 Legislative history: “There was strong backing on the committee for omitting religious corporations from the prohibition of [loans to officers or directors]. Religious corporations were retained within the prohibition largely on the basis of their essential nonfinancial nature. Permitting religious corporations to serve, in effect, as lending institutions appeared to the majority of the committee to be inconsistent with the many privileges accorded to such organizations.”
SD“No loans shall be made by a corporation to its directors or officers. Any director or officer who assents to or participates in the making of any such loan shall be liable to the corporation for the amount of such loan until the repayment thereof.” Rev. Stat. § 47-24-5 (1965)
TN(a) A corporation may not lend money to or guarantee the obligation of a director or officer of the corporation. (b) This section does not apply to loans and guarantees authorized or permitted by any other statute which regulates any special class of corporation. (c) Neither a sale on credit in the ordinary course of business nor a life insurance policy loan shall be subject to the restrictions of this section. Nonprofit Corporation Act § 48-58-303 (1987)
TXA. No loans shall be made by a corporation to its directors.
B. The directors of a corporation who vote for or assent to the making of a loan to a director of the corporation, and any officer or officers participating in the making of such loan, shall be jointly and severally liable to the corporation for the amount of such loan until repayment thereof. Non-Profit Corporation Act § 1396-2.25 (1989)
UT“(3)(a) A loan may not be made by a corporation to its directors or officers.
(b) A director or officer who assents to or participates in the making of a loan in violation of Subsection (3)(a) shall be liable to the corporation for the amount of the loan until the repayment of the loan.” Revised Nonprofit Corporation Act § 16-6a-825 (2001)
Note: This statute permits “conflicting interest transactions” if specified conditions exist, but it is not clear whether this provision applies to loans to officers or directors.
VT(a) A corporation may not lend money to or guarantee the obligation of a director or officer of the corporation. (b) The fact that a loan or guarantee is made in violation of this section does not affect the borrower’s liability on the loan. Rev. Stats. title 11B § 8.32 (1997)
VAArticle IV, section 14 of the Virginia Constitution prohibits the state assembly from granting a charter of incorporation to any “church or religious denomination.” Therefore, churches and religious denominations cannot be incorporated, and so they are not subject to the provisions of the state nonprofit corporation law. However, note that (1) loans to officers or directors may be challenged on the ground that they violate the fiduciary duties of a board who authorizes them; and (2) religious organizations other than churches or denominations may be incorporated under state law and are subject to the provisions of the nonprofit corporation statute. Section 13.1-871 of the Virginia Nonstock Corporation Act prohibits “conflict of interest transactions” between a nonstock corporation and its officers or directors, with certain exceptions. This provision may apply to some religious organizations (other than churches and denominations) incorporated under this statute.
WA“No loans shall be made by a corporation to its directors or officers. The directors of a corporation who vote for or assent to the making of a loan to a director or officer of the corporation, and any officer or officers participating in the making of such loan, shall be jointly and severally liable to the corporation for the amount of such loan until the repayment thereof.” Nonprofit Corporation Act § 24.03.140 (1967)
WVArticle VI, section 47 of the West Virginia Constitution prohibits the state legislature from granting a charter of incorporation to any “church or religious denomination.” Therefore, churches and religious denominations cannot be incorporated, and so they are not subject to the provisions of the state nonprofit corporation law. However, note that (1) loans to officers or directors may be challenged on the ground that they violate the fiduciary duties of a board who authorizes them; and (2) religious organizations other than churches or denominations may be incorporated under state law and are subject to the provisions of the nonprofit corporation statute. Section 31-1-145 of the West Virginia Code specifies that “no loans shall be made by a corporation to its directors or officers. Any director or officer who assents to or participates in the making of any such loan shall be liable to the corporation for the amount of such loan until the repayment thereof.” This provision may apply to some religious organizations (other than churches and denominations) incorporated under the general nonprofit corporation statute.
WI“(1) Requirements for loan or guarantee. Except as provided in subsection (3), a corporation may not lend money to or guarantee the obligation of a director or officer of the corporation unless any of the following occurs:
(a) The particular loan or guarantee is approved by the members.
(b) The corporation’s board determines that the loan or guarantee benefits the corporation and either approves the specific loan or guarantee or a general plan authorizing loans and guarantees.
“(2) Effect of violations. A violation of this section does not affect the borrower’s liability on the loan.
“(3) Limited applicability. This section does not apply to an advance to a director or officer … that is made to defray expenses incurred by the director or officer in the ordinary course of the corporation’s business.” Stats. § 181.0832 (1999)
WY“(a) A corporation shall not lend money to nor guarantee the obligation of a director or officer of the corporation except as provided in W.S. 17-19-853.
(b) The fact that a loan or guarantee is made in violation of this section does not affect the borrower’s liability on the loan.” Nonprofit Corporation Act § 17-19-832 (1992)

Tax issues

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).

Key point. The instructions to Form 1099 specify that “a canceled debt is not reportable on Form 1099-MISC. Only financial institutions, federal government agencies, and certain agencies connected with the federal government are required to report canceled debts on Form 1099-C.” As a result, a church is not legally required to report a canceled debt as income on a 1099 form issued to a former minister. On the other hand, the minister is legally required to report the forgiven debt as taxable income. Many churches prefer to issue a 1099-MISC form to the minister, reporting the forgiven debt as income. Although not required, this insures that the minister properly reports the canceled debt as income.


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).

Key point. A church wants to help its pastor purchase a new home, and so it agrees to pay $50,000 of the purchase price. The pastor signs a promissory note agreeing to pay back the $50,000 in ten annual installments. The church board assures the pastor that the church will “forgive” each annual installment on the date it is due, and so the pastor will not have to pay back anything. Is this transaction legitimate? What are the tax consequences? These questions are addressed fully in chapter 4, section B.16 of Richard Hammar’s 2002 Church & Clergy Tax Guide.

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