Let me mention four issues that are implicated by such a transaction.
- Imputed interest. Any “below market interest rate” loan of $10,000 or more triggers taxable income in the amount of the interest that would have accrued at the “applicable federal rate” of interest. The long-term AFR that applies to loans in excess of nine years is adjusted monthly by the IRS. The rate that applied at the time of publication of this newsletter was 3.57 percent, compounded annually.
- Inurement. One of the requirements for tax-exempt status under section 501(c)(3) of the Internal Revenue Code is that none of a church’s assets can “inure” to the benefit of a private individual other than as reasonable compensation for services rendered. The IRS, and the courts, have ruled in a number of cases that low or no interest loans constitute prohibited inurement which results in the loss of a charity’s tax-exempt status.
- Excess benefit transaction. According to section 4958 of the tax code, any benefit provided by a tax-exempt organization to an employee that exceeds the reasonable value of the employee’s services constitutes an “excess benefit transaction” that exposes the employee to substantial excise taxes (called “intermediate sanctions”) of up to 225 percent of the amount that the IRS determines to be excessive compensation. This penalty only applies to “disqualified persons,” who are officers or directors of the charity, or a relative of such a person. In addition, members of the organization’s board who approved the excess benefit are subject to an additional excise tax of 20 percent of the amount of the excess (up to a maximum penalty of $20,000, collectively). As a result, if the imputed income is not reported as taxable income, it will constitute an automatic excess benefit under section 4958 of the tax code that will expose the pastor and board members (who approve the loan) to the excise taxes described above.
- Nonprofit corporation law. Most state nonprofit laws provide that board members who authorize a loan to an officer or director are personally liable for the repayment of that loan. Let me stress that this rule generally applies to any loan to an officer or director, even loans at a commercially reasonable rate of interest. Be sure to check your state law on this issue. If your state nonprofit corporation law contains such a provision, then the board members who approve the $50,000 loan will remain personally liable for its repayment until it is paid in full. In summary, below-market interest loans raise a number of complex and significant legal and tax issues that need to be addressed. I have simply attempted to alert you to the most important issues. I would recommend that the church seek legal counsel in the event that you choose to pursue this arrangement.