The tax-exempt status granted to churches by law is fundamentally designed such that its benefits are essentially funneled to the churches themselves. If an individual receives too much benefit from a transaction with the church—in the form of payment by the church for products, property, or services that goes well beyond market value—particularly if that person is somehow linked to the church in one of a number of key ways—then the IRS may choose to impose sometimes severe penalties on the church. That is to say, the only parties that may benefit when a church enters transactions with third parties are the church itself and the third party—and that third party must not be someone who is defined as a “disqualified person.” Any transaction that violates this principle is called an “excess benefit transaction.”
“Disqualified persons” are (for example) those who are:
- part of the leadership of a church,
- someone closely related to a person in a leadership role (such as a parent, child, or spouse), or
- any business or other organization whose ownership is more than 35 percent in the hands of such a person.
An excess benefit transaction can come in a number of different forms, such as outsized compensation packages, the renting of property owned by a disqualified person at rates above market value, loans granted by the church at interest rates below what the market can bear (or no interest at all), or purchase of property at rates well above market value from such a person.
Excess benefit transactions—particularly those not reported to the IRS in tax filings—are subject to penalty at the federal level. Not only may the “disqualified individual” receiving the “excess” benefit be required to repay to the church whatever portion the authorities deem to be the excess amount, with an added excise tax of 25 percent, but an extra penalty may be demanded of any management individuals who knew about the excess benefit transferred in the transaction—to the tune of 10 percent. There have even been cases in which the IRS decided to revoke the church’s income tax exempt status altogether. Any reported excess benefit transaction needs to be carefully documented and justified, and reported in whole.
Provident Law’s church and nonprofit attorneys can help in determining when a transaction qualifies as an excess benefit transaction, and can counsel churches through the process of any transaction. We also stand ready to counsel and serve charities, foundations, private schools, colleges, universities and other types of nonprofit organizations—providing broad transactional and general counsel services in Arizona and surrounding areas. Contact us to learn more.