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Get Ready for an IRS Audit!
What are the chances of an IRS audit against my ministry?
Good question! Historically, chances have been low...maybe too low. It is a well documented fact that more than 85% of churches have compliance issues. Issues that need resolution. Now that the post-denominational era has been well established, and the majority of church startups are independent and non-denominational, IRS and state law compliance enforcement is at a historic low. I see a perfect storm brewing. There are three important components of this storm.
First, we'll look at Section 4958 of the Internal Revenue Code which was enacted July 30, 1996. Over the years, Congress has tweaked this section of code, and in March of 2008, the IRS published final regulations that affect how the law is applied and how it relates to tax exempt entities like churches and ministries.
In the past, the IRS did not have much incentive to go after churches because there were no penalty provisions in the law that motivated them to do so. The budget for church audits had to come out of the IRS's own pocket and the worst result of an audit was that the church could lose its tax exempt status for major violations. Things have changed! Section 4958 is now the IRS's golden egg because it gives them power to heavily penalize churches and their leaders for private inurement violations.
Now that it can impose hefty fines to fatten its coffers, you can be sure the IRS will act quicker and with increased vigor. IRS commissioner, Mark Everson, said that the IRS is going to invest three-hundred million dollars to ". . . reinvigorate our enforcement presence."
Second, we'll look at my concern over the huge increase of independent churches. Don't get me wrong, I think it is great to see new growth in the Body of Christ; each church with its own unique expression of love for God is a beautiful thing. I would like to see more churches start up. As long as there are unsaved people in your city, there is room for one more church. My concern is with the direct correlation between the number of new churches and the increase in non-compliance issues. Independent churches do not necessarily have a central office or denominational headquarters to rely on for tax and compliance education or financial accountability. They are on their own and the statistics are simply dismal.
Third, I want to note how public policy and legal opinions have been ever changing. Public opinion has been steadily moving to the left when it comes to churches and taxation. Courts have ruled that church tax exemption is an "act of legislative grace" and not guaranteed by the Constitution. Additionally, courts have concurred that the only provision giving churches tax exempt status is Section 501(c)(3). There is also legal precedence interpreting Section 508 to require all churches (regardless of whether or not they actually apply for 501(c)(3) status) to comply with all the provisions of Section 501(c)(3) in order to be tax exempt. Whether you agree or not, this is how the law is being enforced, and public outcry over government transgression against religious organizations is losing volume. Local, state and federal government agencies no longer see churches and ministries as untouchable.
These factors combine to create a stormy future for the church that will catch many by complete surprise.
What will the future hold?
I see a season of increased IRS audits against churches. These audits are going to yield big profits for the IRS. I see it happening so intensely that some churches will experience having to forfeit properties due to tax fines, while others might simply have to close their doors for good.
Will the IRS seek to put pastors in prison?
No! Fortunately, that has never been the IRS's agenda. While some pastors have gone to prison for tax evasion or embezzlement, none have been put in prison for non-compliance issues. The IRS is simply after the tax fines it can impose for non-compliance.
I have heard the cries of some who say the IRS is imprisoning pastors for even the smallest of infractions. This is a complete farce. You may have even received promotional materials with pictures of pastors in handcuffs or courtrooms with a Jury deciding the fate of a pastor. The notion that the IRS will twist a small compliance issue into a full prosecution against the pastor is a concoction of half truths. These voices use fear and intimidation, and I find it a grievous offense against the Body of Christ.
What does a typical IRS audit involve?
When the IRS audits a church, it must comply with the provisions of Section 7611. This section of the code gives clear guidelines on how an audit against a church shall proceed. It was passed by Congress as a "protection for the church." I do not see it that way. It gives the IRS far too much power, and once scaled by the IRS, the "wall of protection" is worthless because churches lose their right to appeal.
So what should your church do to be ready if the IRS comes knocking at your door?
1. Ensure that you are operating in activities that are consistent with your exemption. This is a big one, yet many church leaders are unaware of it. When the IRS audits a church, they spend very little time auditing income and expenses and more time looking into deeper things. They DO NOT audit a church the same way they would audit a for-profit business. Instead, they zoom in on your church activities to see:
- if they are consistent with "normal" church activities,
- if they are consistent with your articles of incorporation,
- if they further the purposes of the church,
- if any of them violate the constitution and bylaws and
- if your church engages in any political activity
It is important to understand when the church engages in activities outside of traditional church worship services, it must document how the activity furthers the church's exempt purposes.
2. Keep accurate records of board meeting minutes. A large part of an audit will focus on the minutes because it is here that all decisions should be recorded. Most churches have a terrible time keeping minutes. Many lose them when moving from one facility to another. I spoke with a church administrator from Ohio that went through a week long audit of her church. She said that the majority of time was spent looking at the activities, minutes and policies to make sure that all relevant compliance decisions were properly documented. Please, do not underestimate the importance of church minutes. They will save you in an audit.
3. Make sure that any funds given to the pastor, or other church leaders, are properly documented. Section 4958 is very clear that even if the pastor's salary is reasonable, failure to properly document it as taxable income will result in either a 25% or 200% fine against the pastor. Moreover, reimbursements to the pastor must be done correctly or they will be subject to the penalties of Section 4958.
4. Look out for unrelated business income. Many churches incur unrelated business income (UBI) when they engage in activities that are unrelated to their church purposes. This may happen when a church engages in renting out old facilities, or perhaps when they open a bookstore or gym facility. Unless these activates meet certain guidelines, they are considered taxable. Most churches are just simply unaware of these issues. Again, this is all tied in with your activities. In order for revenue generating activities to be tax exempt, they must satisfy two requirements:
- The activity must be substantially related to the organization's exempt purpose or function.
- It cannot be conducted as a trade or business.
Keep in mind, it is OK if the church has some unrelated business income as long as it reports the income and pays the taxes on it. I know of a church in Florida that purchased a business park and it uses one part of the facilities for its church and offices and the other part it rents out to businesses. The rent they collect is greater than the mortgage they pay. Every year they file a tax return to pay the unrelated business income tax (UBIT). What is not OK is when the church does not report it as taxable income. Most UBIT audits against churches come about when a competing business files a complaint to the IRS, some examples being bookstores, daycare centers, advertisers and parking lot businesses.
5. Be very tedious about minister ordinations and the documentation of those who are ordained, licensed, or commissioned. Courts have been very inconsistent with the way they handle ministers with regard to taxes. They have been clear that a minister is considered a minister for self employment tax purposes when he or she engages in the work of the ministry and receives at least $400.00(or more) in any two tax years. However, when it comes to the housing allowance rules, the IRS does an about face; which results in a disapproval of the housing allowance. Please, it is important that you get this part right!
There are many other issues that an IRS agent will look at when performing an audit. We discuss those issues in detail at our conferences. From use of personal cell phones to church owned automobiles, we will cover all of the topics that will empower you to get your church in compliance. To see a full list of our upcoming conferences, please click here.
A final word
I want to reiterate that this article addresses a real truth about the perfect storm I see brewing. I challenge you to take the business side of ministry to a whole new level of excellence. It can only bring about good things for your church or ministry.
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