Before the IRS Calls on Your Church

by Dan Busby, ECFA President

Is there a high risk your church will be audited by the IRS? No. Despite those who try to entice church leaders to come to their seminars by implying the IRS is lurking behind every tree, the risk of an IRS audit at your church is very low. (There is a higher risk that the Department of Labor will audit your church for Fair Labor Standards Act violations—but that is another topic for another day!)

The IRS does perform full scale audits on churches. While the IRS does not disclose church audit data, insiders suggest the church audits are in the range of 100 per year—and the churches audited are those exhibiting the most egregious behavior. An employment tax audit of a church—which is a very limited audit--is not unusual.  Many churches are very much at risk in the employment tax area because of inadequate policies and practices.

There is a special provision in the Internal Revenue Code (Section 7611) which requires “an appropriate high-level Treasury official” to approve a church tax inquiry. (However, there are many exceptions to this requirement.  For example, church tax inquires and church tax examinations do not apply to the filing or failure to file any tax return or information return by the church or compliance with income tax or FICA tax withholding.  So, an employment tax audit can generally be started without reference to Section 7611 of the Code.)

Marcus Owens, Attorney with Caplin & Drysdale in Washington, D.C. (and formerly the head of the IRS division), recently commented at the Washington Nonprofit Legal & Tax Conference:  “The IRS is wearing down the Section 7611 audit threshold.  If a church is audited after the IRS has scaled the Section 7611 wall, the church loses its appeal rights.”

There are several appropriate steps to take before the IRS comes to call:

  • Review your activities.  Does the church have documentation to establish the relationship between the various church programs and your exempt purpose as a church? Today, churches launch a wide variety of ministries. Documenting the relationship of each ministry to the mission of the church is a fundamental principle.

  • Review your records.   Are the basic records of the church (legal, financial, donor, personnel) stored on the church premises and labeled accurately? Many of the church records may be stored electronically on the church network. Does the church have a records retention policy and follow the policy?

  • Recognize all employees as employees.  Does the church have clear policies to determine which workers are employees v. independent contractors? Does the church err on the side of classifying workers as employees? This topic is a hot-button with the IRS. They will tend to classify all workers as employees. If the church has classified workers as independent contractors and the IRS views them as employees, the IRS will assess FICA taxes (both halves—15.3%) and federal income tax withholding, plus penalties and interest—often going back three years.

  • Stay current on employment tax filings.  Are payroll tax returns (Forms 941) timely filed each quarter and payroll tax deposits made when due? If the church is running close on cash, never borrow from the funds that are due to the IRS for payroll tax.

  • Consider any unrelated business income (UBI) filing responsibilities.  Many churches have an obligation to file a UBI return but are unaware of this duty. This is an easy problem for the IRS to find.  What triggers UBI filings? Just $1,000 of gross unrelated business income requires the filing of Form 990-T. There is generally no tax to pay but the filing is still required. What is one of the most common types of UBI?  Rental income from mortgaged property. There are many other kinds of UBI but this is a frequent issue for churches.

  • Keep your information filings up-to-date.  There are a myriad of other filings that may be required with the IRS. Some common examples are:  Form 5578 that must be annually filed if the church operates a private school. Form 1099-MISC that must be filed for independent contractors (be sure your files contain justification for independent contractor status). Form 1099-INT must generally be provided to recipients of $10 or more of interest income. All payments to nonresident aliens, other than expense reimbursements and amounts reported on Form W-2, must be reported on Form 1042 and 1042-S (these filing are often overlooked and the IRS has this problem on the top of their list).

  • Carefully document the status of ministers.  If a church treats an individual as a qualified minister, has the church clearly documented ministerial status? Is a copy of the ordination, licensing or commissioning document in each minister’s personnel file? Has the church documented the position description of each minister?

  • Properly document the personal use of church-owned or leased vehicles.  While not much tax money is involved, this issue is low-hanging fruit for the IRS.  Church staff members are obligated to track any personal mileage, including commuting miles, on any church owned or leased vehicles they drive. The personal use mileage must then be taxed to the staff member using one of the methods approved by the IRS. If the church takes the position that a church-owned or leased vehicle is never used for personal purposes, this will rarely fly with the IRS unless we are talking about a Sunday school bus!

  • Identify the personal use of cell phones.  The personal use of cell phones is another hot item with the IRS. The IRS Regulations in this area are very strict—almost beyond the point of possible compliance. At a minimum, however, a church must make a reasonable effort to identify the personal use portion of cell phone usage from a compliance and risk management standpoint.  It isn’t enough to say the church bought so many minutes and didn’t go over the limit. While neither option literally complies with Regulations, most churches that pay for church staff cell phone time either gross up the employee’s Form W-2 or require a reimbursement for the personal use portion.

  • Properly handle spousal travel expenses.  The spousal travel expenses of church staff members do not qualify for reimbursement by the church unless the spousal travel qualifies as business expense. Even if it appears there is a business purpose for the spousal travel, the key is documentation, e.g., documenting the purpose for spousal travel on a trip-by-trip basis.

Summary.  While this article focused on specific steps to take before the IRS calls, my next article will address more general church internal audit procedures every church should follow. Following the steps outlined in the two articles combined will help your church maintain financial integrity and accountability—certainly a worthy goal!

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