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31 May 2018

Court Makes Surprise Ruling in Church Audit Case

Raul Rivera

One of the last things any pastor wants for his/her church is to have to go through an IRS audit.

Thankfully, there is a stringent process that the IRS must abide by when it comes to conducting church audits.

For instance, the law governing church audits states that the IRS can begin a church audit only “ . . . if an appropriate high-level Treasury official . . .” has reasonable belief that a church audit is necessary.

But what and who is “an appropriate high-level Treasury official,” and what constitutes a “reasonable belief”?

The US District Court of South Carolina* recently provided a little clarity when it ruled that the director of Exempt Organizations Divisions does not hold a sufficiently high enough position within the IRS ranks to initiate church audits.

While this is good news for churches, we still need to understand what constitutes “reasonable belief” in the eyes of the IRS. We’ll take a look at that next.

What does it mean for the IRS to have reasonable belief?

In short, section 7611 of the tax code says that for a church tax inquiry to occur, an appropriate high-level Treasury official only needs to reasonably believe, on the basis of facts and circumstances in writing, that:

  • the church may not be operating as a tax-exempt entity, and
  • that the church may be carrying on an unrelated trade or business.

I placed an emphasis on “unrelated trade or business” for two reasons:

  1. because that’s how I believe many churches can find themselves in a “sticky” situation with the IRS, and
  2. when income is generated through unrelated trade or business activities, unrelated business income tax MUST be reported to the IRS via Form 990-T.

Since unrelated business is something the IRS looks for and is mindful of, I want to spend the rest of this blog sharing with you what an unrelated trade or business is and how your church can avoid it and benefit at the same time.

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What does an unrelated trade or business look like to churches?

To understand what an unrelated trade or business is, we have to begin by looking at three sections of the tax code: sections 511, 512, and 513.

  • Section 511 imposes a tax on income to an organization that is derived from an activity that is not related to its tax-exempt purpose.
  • Section 512 defines the term “unrelated business taxable income” as any gross income derived from an unrelated business activity that is regularly carried on by a tax-exempt organization.
  • Section 513 defines the term “unrelated trade or business” as “any trade or business the conduct of which is not substantially related . . . to the exercise or performance by such organization of its charitable, educational, or other purpose or function constituting the basis for its exemption under section 501.”

In short, these three sections tell us that prior to an activity of your church being considered an unrelated business activity and the income derived from such activity being considered unrelated business taxable income, the following three conditions must be met:

  • The activity must be considered a trade or business.
  • The trade or business must be regularly carried on.
  • The trade or business must not be substantially related to the exempt purpose of your church.

It is important to note that there are exceptions to unrelated trade or business activities.

The specifics of the exceptions are out of the purview of this specific blog; however, you can click here to read about the exceptions to unrelated trade or business activities.

The best way for churches to avoid an audit due to unrelated business activities

I applaud ingenuity and thinking “outside of the box” when it comes to generating income to further the kingdom of God.

However, I encourage you to proceed with caution regarding your church’s current, or possibly future, unrelated business activities.

I say this because when the IRS considers your unrelated business activity and income, the IRS weighs them against your church’s tax-exempt activities and total annual income. 

If your church’s unrelated trade or business constitutes more than an “insubstantial” part of its activities, then your church’s tax-exempt status could be in jeopardy of being revoked.

Rather than taking this risk, the best alternative to this potential problem for your church is to start a for-profit arm.

In essence, a for-profit arm is a business venture of which your church is a majority shareholder. In return, the for-profit arm pays the church profits in the form of tax-free dividends.

This is a strategy that we teach to pastors and church leaders at our conferences all across the country. If you would like to learn more about this strategy for your church, then I invite you to join us at one of our upcoming conferences. You can click on the link below to find out more information. 

Lastly, if you have questions about your church’s structure and church compliance, then give us a call at 877-494-4655. One of our team members will be happy to help!

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Citation:

  • United States v. Bible Study Time, Inc., No. 7:17-cv-02810-CMC, 2018 U.S. Dist. LEXIS 40619, 121 A.F.T.R.2d (RIA) 1007 (D.S.C. Mar. 13, 2018)

Please feel free to comment. We always appreciate good dialogue. However, we do moderate each comment to ensure that it is on topic and not derogatory to other participants. We ask that you keep your comments brief and pertinent to the topic so that others may benefit.

Blessings,
Raul Rivera

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About the Author

Church Planter. Speaker. Author. CEO. Raul Rivera has had ample experience in the church planting world. His current venture, StartCHURCH, has helped 1000's of churches to start right. Raul has compiled an array of manuals and software tools that help churches stay compliant with the IRS. He also hosts over 35 national conferences per year, training pastors on how to launch their churches. Raul is married to his wife Genel, and they and their five children live in Atlanta, GA.