Why Churches Get Audited

Has your church ever been audited by the IRS? I would suspect most churches can answer no. Because churches are tax-exempt, they don’t file a standard income tax return, or fill out Form 990, so there’s less scrutiny from the IRS than for other types of organizations. 

According to the IRS, they won’t initiate a church audit unless they believe a church doesn’t qualify for tax exemption, didn’t report unrelated business income tax, or entered into an excess benefit transaction with a disqualified person.

In fact, Congress has imposed special limitations on how and when the IRS can conduct church audits, which are called church tax inquiries.

While these may seem like very narrow conditions, they actually cover a lot of areas.  However, it’s important to note that these narrow conditions do not apply to individual audits of ministers, church employees or church schools.

Additionally, the IRS says that they can start an audit based on an anonymous phone call or a newspaper report as long as it seems reliable. As a result, there are still many ways that churches can get the IRS’s attention.  Here are four ways churches can get audited (and a fifth way that might get the state attorney general’s attention):

 

1. Stepping outside the church’s exempt purposes. Here are several ways churches can step over the line:
   a. Inurement. Churches cannot allow income or assets to unduly benefit insiders such as ministers, officers, board members, and employees.
   b. Private Benefit. Churches must direct their resources to charitable, educational, or religious purposes rather than benefitting a few private individuals, financially or otherwise.
   c. Lobbying. Churches may not use a substantial part of their activities to influence or lobby for legislation.
   d. Campaign Activity. Churches must not participate in, or intervene in, any political candidate’s campaign for public office.
   e. Illegal Activity. Churches cannot participate in activities that are illegal or violate public policy.
   
   

2. Not reporting unrelated business income.  If a church has $1,000 or more in gross income from an unrelated business, it must file Form 990-T, Exempt Organization Business Income Tax Return. There are several criteria to determine if income is subject to the unrelated business income tax (UBIT). Similarly, there are a few exclusions, like dividends, interest, and gains or losses from selling property. Rental income from real property is also excluded (but not personal property). However, if the real property has a mortgage, then the income could be subject to UBIT. 
   
   

3. Payroll errors. There are a myriad of rules, forms, and deadlines involved in processing payroll. Due to the complexity of this area, some of the more common errors for churches involve proper classification of ministers, properly reporting all taxable income, and the proper withholding and reporting of taxes. The IRS will especially take notice if churches fail to correctly withhold and make payroll tax deposits, or fail to file Form 941, Employer’s Quarterly Federal Tax Return.
   
   

4. Excess benefit transactions. This is defined as providing a financial benefit to a church leader (someone that has substantial influence) that exceeds the fair market value of services they provide to the church. Examples include an unreasonable compensation package or providing a loan with below-market interest rates.
   
   

5. Using restricted donations for other purposes. When a donor designates a gift for a specific purpose such as missions, or a building fund, it becomes restricted for that purpose. Churches should respect and adhere to these restrictions which will help maintain the donor’s trust and allow the church to operate above reproach. But here’s another good reason to honor these designations: these restrictions may be legally enforceable under state law. 

Why church leaders should pay attention

In some of these cases, the individual employee and/or the church’s board members can be held liable for these errors.  While the IRS could revoke the church’s tax-exempt status, they are more likely to assess additional taxes, called intermediate sanctions. These excise taxes can be levied against the individual employee and the church’s board members who authorized the transactions.   The employee can receive excise taxes up to 225% of the financial benefit, and board members can receive excise taxes of 10% of the financial benefit, up to $20,000 maximum. 

Consider these recent cases where churches and nonprofits were investigated by the IRS or state attorney general:

• The IRS sent Federal Marshalls to seize the Indianapolis Baptist Temple in 2001 for failing to pay $6 million in payroll taxes. 

• The IRS placed a lien on a church in FL for failing to pay $400,000 in payroll taxes. The church had to close the church school and lay off 23 employees. 

• NY’s attorney general sued a pastor and board for misusing church funds for personal use. The pastor had to pay back $1.2 million, the executive director had to pay back $482,000 and 3 board members were fined $50,000.

• A nonprofit president and board members in New York were fined $5.5 million for conflict of interest and excess compensation issues.  

• California’s attorney general sued a nonprofit and its board members for improperly using restricted funds.  

How do you protect your church from these risks?

While the risk for an IRS audit or a visit from the state attorney general may be low, it is important to keep these issues in mind as you manage the financial operations of your church. Know the boundaries of what is proper and legal and set an expectation for compliance that everyone should follow. If you need additional expertise, consider hiring an outside vendor to help manage your church’s finances and payroll. With a little due diligence, you can protect your church’s integrity and reduce the chances of the IRS audit.