Compensation for past years!

By Raul Rivera

Last week we briefly covered the issue of compensating pastors for previous, un-paid years of service, and that it is perfectly legal to do so. This stems from a court case involving a church who paid a pastor and his [missionary] son in lump sums for the years of work they performed for the church without pay. The church decided to sell its building for $834,000.00 and use a portion of the proceeds to pay the pastor and his son a lump sum so they could pay off their home mortgages of approximately $362,000.00. Some church members did not agree with that, and filed a lawsuit against the church to prevent the sales and distribution of the proceeds. The church members involved in the lawsuit argued that this was an improper use of church funds. The court disagreed. It stated that a religious corporation may consider past services when putting together compensation packages, but that the church must exercise due diligence to ensure that the compensation is reasonable. The court also made it clear that Section 4958, which was enacted in 1996, provides severe penalties, or intermediate sanctions, against organizations and board members who pay excessive benefits to their officers or insiders. Let me explain!

What about excess benefit transactions?

The church was already paying the pastors (father and son) a regular salary at the time the building was sold. In addition to their salary, they each received approximately $200,000.00 as a special gratitude for the sacrificial work they had done in the past. While the court agreed that the church was able to consider past years, it noted that the IRS still had the right to scrutinize the total compensation and determine if it was reasonable for that year. Additionally, the court ruled that there are two types of compensations that could occur for past years.

1. A church considers past years while putting together a compensation plan. The church must determine if the regular pay, combined with the past years compensation, is reasonable for that tax year.
2. When a church promises compensation at an ". . . earlier date to be paid at a later date . . ." when the church can afford it.

In the descriptions given by the court, we see two types of past years compensation plans that can be used. The first limits the amount paid, in addition to the regular salary, to the strict requirements of Section 4958, as interpreted by the IRS in Private Letter Rulings 200435019, 200435020, 200435021, 200435022. Below are three steps to follow when considering this type of compensation plan for past years.

1. Compensation for past years must not exceed the total amount of what is reasonable for any given year. For example: In the year 2009, a pastor receives a salary of $55,000.00, plus the church decides to pay him an additional $30,000.00 to cover the last two years. This brings his total compensation up to $85,000.00 for 2009. The question at hand is whether or not the total compensation of $85,000 is reasonable for the whole year.
2. Make sure the church gives the pastor a W-2 for the regular salary and the extra compensation.
3. Make sure the pastor reports the regular salary and the extra salary on his or her tax return.

The second plan allows a church to pay lump sums for previous years, but only if the following conditions are met:

1. The church enters into a contractual agreement with the pastor to pay him a salary for the work that he does. However, not all of the compensation promised in the contract is paid.
2. The church then records it into its books as an accounts payable.
3. When able, the church pays the pastor in a lump sum or as often as they are able.
4. Any amount paid to the pastor gets reported on the pastor's w-2, and the pastor is required to report it on his Federal 1040 tax return and State tax return, if applicable.

As for the church that wanted to pay the father and son the $362,000.00? The court ruled that the church could consider past years, but it also remanded the case back to the district court to determine whether the $362,000.00 was fair compensation. This happened because the church could not prove that there was a contract signed between the church and the ministers during the years that they served with little or no pay.
Under the regulation of Section 4958, the church has to prove that the extra compensation of $362,000.00 above their regular salaries was reasonable, and that it furthered the purposes of the church. What should have been a $834,000.00 blessing to the church turned into a fight that lasted for years in court. If the church is unable to prove the reasonableness of the extra pay, the IRS can then issue intermediate sanctions of up to 200%. In this church's case, that is a fine of $724,000.00!
With the increased scrutiny under the IRS Exempt Organizations Executive Compensation Compliance Initiative, we urge churches to know all the facts before approving compensation for past years. We can help you with this task. Click here for more information.