Churches that have chosen to incorporate will need to select a board of directors that will oversee church management and finances. A church’s director has certain fiduciary duties with respect to the church, its members, and other directors. The duty of loyalty is one fiduciary obligation that can cause problems for a director who does not understand it.
The duty of loyalty is, in simplest language, an obligation to put the church’s interests before one’s own. The contours of the duty of loyalty are mostly defined by state law, but it also can become an issue in the tax setting as well.
An overarching principle of the duty of loyalty is that directors of a religious corporation must be sensitive to potential conflicts of interest between their personal or professional lives and the business of running the church. If a director can directly or indirectly benefit from a decision being made by the board, that director may need to step away from the board’s deliberations and voting on the issue. A personal benefit can include personal financial gain, but it also includes nonmonetary benefits, and benefits to a family member, such as an offer of employment to a director’s spouse or children.
Bear in mind that many conflicts of interest need not be serious impediments to going forward with a given transaction. The key is that conflicts are recognized and processes put in place to ensure that the board’s decision is made with due consideration for how the conflict of interest may influence the directors in a way that undermines their obligation of loyalty to the church.
A special category of conflicts of interest is reserved for self-dealing transactions, in which a director, the director’s business, or a member of the director’s family or one of their businesses will receive a material financial gain through a particular transaction. Examples might include the sale of property owned by the director to the church, or an engagement of the director’s business for services. Before such a transaction can take place, it must meet certain requirements, including that it is fair and reasonable for the church, it was approved by the non-interested directors with a complete set of facts about the transaction, and that the board has determined in good faith that a better deal was not available under the circumstances.
A self-dealing transaction can create potential tax liability for the church, the involved director, and other approving directors if the compensation paid by the church to the director (or the director’s business, etc.) is in excess of the benefit received by the church. The potential for the IRS to label a deal as an “excess benefit transaction” should give directors pause before they consider entering into a major deal that could trigger this rule. For example, if a church plans to buy property from a director, the church will need to engage an outside firm to ensure that the price being paid is fair and will not trigger excess benefit rules.
The Church Law Center of California provides governance guidance to religious and secular nonprofits. We can counsel your church’s leadership team about how to avoid conflicts of interest and maintain high standards of accountability. Call us at (949) 689-0437 or reach out to us through our contact page.