A key requirement of the special tax treatment granted by state and federal law to churches and other nonprofit organizations is that they must not be operated to financially benefit particular individuals. However, from time to time a church may do something that threatens to cross the line by providing a significant financial boost to a member of the church’s management or one of their family members. Such transactions are called excess benefit transactions. If left unreported on the church’s tax filings, excess benefit transactions can lead to expensive penalties.
An excess benefit transaction involves the church exchanging more than fair market value for goods, services, or other things of value offered by someone who is in a leadership role within the church, someone closely related to them (a sibling, parent, child, and so forth), or an organization such as a business that is at least 35% owned by one of these individuals. Such people and organizations are called “disqualified persons.”
Excess benefit transactions can come in many forms. Here are a few examples:
- Purchases of property from a disqualified person at above fair market value or with terms that aren’t typically seen in arms-length transactions.
- Compensation packages that are particularly large.
- Renting property from a disqualified person at above-market rates.
- Loans given by the church to a disqualified person at low or no interest.
At the federal level an excess benefit transaction can have serious financial consequences. The person benefitting from the transaction may be ordered to pay the “benefit” portion back to the church, and may have to pay an excise tax of 25% on top. Another 10% penalty may be assessed against managers who knew that the transaction created an excess benefit. In extreme cases the IRS can also revoke a church’s exemption from income taxes.
Churches should take care to closely examine any transaction with a disqualified person that may trigger the excess benefit rules. Excess benefit transactions need to be reported on the church’s tax returns and, in the case of employee compensation, on employment tax forms, such as the employee’s Form W-2. To reduce the risk that the IRS will impose penalties for such transactions it’s vitally important that management carefully examine the transaction and document its decision-making process. It may be that a star pastor is worth an unusually high compensation package, but the methods used to arrive at the final numbers should be documented and defensible, and the compensation itself reported to the IRS. Failing to properly report an excess benefit transaction exposes the church itself to penalties.
The best course of action for a church that is contemplating entering into a transaction with someone who might be on the “disqualified” list is to consult with a tax advisor and attorney as part of the transaction planning process. The Church Law Center of California provides legal counsel to churches in all phases of their governance. Call us today at (949) 689-0437 or reach out to us through our contact page.