Can Donations Risk Your Tax-Exempt Status?

Written by Raul Rivera on Oct 16, 2016 in IRS Compliance

Raising enough funds to sustain a church is no easy task. In fact, it is a “thorn” in the side of many pastors.

Pastors I speak with have grand visions for reaching their community but struggle to make those dreams reality with only the tithes and offerings received on Sunday mornings.

Especially in the beginning stages of a church plant, pastors may find themselves paying out of pocket for many expenses or barely scraping by with what comes in the offering plate. Often, churches turn to fundraisers to help generate the money needed to pay bills or even start new ministries.

While fundraisers can be a great source of revenue, if not managed correctly, they can potentially risk your church’s tax-exempt status.

A common example

Consider the following example of a church in South Carolina that found itself in “hot water” over a fundraising event.

Pastor David and his board of directors had been putting off repairs to their church building for quite some time. They knew the building needed a new roof, but the church simply did not have enough funds to pay for it.

One day a generous donor gave the church a used car, with the hope that the church could sell it to help pay for the repairs.

The church board considered their options and decided to do a raffle to generate as much money as possible from the car.

The church sold tickets for $2.00 a piece for a chance to win the car. Within the first week, the church generated over $500 in raffle ticket sales. Pastor David was thrilled with the success of the raffle.

But little did he know, the church was breaking state law!

With all the publicity and hype around the fundraiser, word got to the local authorities about the raffle. The police visited the church and brought them the bad news.

The church did not realize that Article XVII, subsection 7, of the South Carolina Constitution prohibits raffles, and section 16-19-10 provides a penalty of $1,000.00 and a one-year sentence in prison.

Thankfully, the police did not charge the church with a crime. They only requested that the church refund the money to participants, which they did, and all was forgiven.

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Though this is only an example story, it happens every day. In fact, you may read it and realize how close your church could have come to a similar situation.

Four common sources of income

Some churches mistakenly believe nonprofits can only receive funds through donations, such as tithes and offerings. Others seek alternative sources of income like raffles or other gaming events without regard for the legal ramifications.

There are a variety of ways a nonprofit, such as a church, can generate and receive funds. The four most common sources of income include:

  • Donations
  • Income from a service or product provided
  • Fundraising
  • Gaming

Let us take a closer look at each source of income.

1. Donations

A donation is money given of free will that is not in exchange for a good or service. Typically, the donor relinquishes control of the donation allowing the nonprofit ultimate discretion as to how the money is used.

Donations, such as tithes and offerings, are the most common source of income for churches. Churches can also utilize fundraising campaigns to encourage giving for large-scale projects such as building campaigns.

Income received through fundraisers is still tax-deductible as long as donors relinquish control of the donations and do not receive anything in return.

2. Income from goods and services provided

Another source of income is from the selling of a service or product. Some nonprofit organizations rightfully charge fees for their services.

For example, nonprofit schools and daycares may charge tuition, and many transitional housing facilities have low-cost program fees to supplement the care and training provided to residents.

These types of nonprofits are still permitted to receive tax-deductible donations and receive income from fees for services charged. This is because they are serving the purpose of section 501(c)(3) by providing their services exclusively for religious, charitable, scientific, testing for public safety, literary, or educational purposes.

Churches more commonly use fundraisers such as bake sales, garage sales, silent auctions, concerts, or banquets. As long as these types of activities are infrequent, the income generated will not harm the nonprofit status of the church.

However, as we will see shortly, with such activities you should always be mindful of unrelated business income.

When a nonprofit organization receives substantial income from a regularly carried out activity that is not related to its tax-exempt purpose, the organization must pay unrelated business income tax.

If the business activity is substantial, the IRS may choose to revoke the tax-exempt status of the organization. This would only happen if the IRS deems the nonprofit is no longer functioning as a nonprofit, but instead it is operating more like a for-profit business.

3. Fundraisers and gaming

Thousands of churches every week do some sort of fundraising activity in order to further the church’s purpose and dream.

Many churches sponsor or conduct dinners, car washes, auctions, bake sales, and candy sales without thinking of whether there are any legal requirements or consequences.

While #fundraisers can be a great source of revenue, if not managed correctly, they can potentially risk your #church's #tax-exempt status.

Gaming is most often portrayed as a fundraiser through raffles, bingo, or casino nights. Relying solely on this type of income to fund your ministry can jeopardize the ministry’s tax-exempt status because gaming is not a tax-exempt activity. 

Additionally, each state has laws that govern gaming for nonprofits and businesses alike. As we saw in the example of Pastor David above, it is important to look into your state’s laws about gaming activities before planning your fundraiser.

4. State gaming laws

Every state has its own laws about gaming, which includes raffles and other games of chance.  Some states have a statewide constitutional ban against gaming. Other states have laws that prohibit, limit, or require special registration and licensing for nonprofit organizations and churches.

Below are a few examples of the variety of state laws on gaming:

  • Georgia allows churches to conduct a raffle. Subsection 16-12-22.1 says that a bona fide church that is properly registered can operate a raffle as long as it registers the raffle with the county sheriff.
  • In the state of Maryland, a raffle has to be registered with the county. If the raffle takes place in Baltimore City, it has to be registered with the city as well.
  • West Virginia requires that the church or nonprofit be in existence at least one year before conducting a raffle.
  • Arizona requires that an organization be in existence at least five years.

Unrelated business income

While most churches are simply conducting fundraisers to help fund the vision that God has given them, many do not realize that the very income they are receiving may jeopardize their federal tax-exempt status.

IRS Code sections 511, 512, and 513 govern how and when a fundraiser becomes a taxable unrelated business activity:

  • Section 511 imposes a tax on income to the church that is not related to its exempt purposes. 
  • Section 512 defines taxable unrelated business income as income derived from an unrelated trade or business. 
  • Section 513 defines unrelated business activities as any trade or business the conduct of which is not substantially related to the exercise or performance by such organization of its charitable purposes.

Proceed with caution

Now, I want it to be clear that in no way am I saying your church should not participate in fundraising activities.

In fact, it is okay to use more creative methods to raise funds for your ministry. However, it is very important to consider all of the ramifications of your fundraising efforts so that they are only beneficial to your organization.

If you have not yet had the chance to do so, I want to encourage you to attend one of our Ultimate Church Structure Conferences. During this one-day event, you will learn about a strategy that will allow you to no longer rely upon fundraisers to fund the dream God has given you.

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Raul Rivera

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