Heart is Good, Advice is Bad

Written by Trey Lewis on Apr 27, 2017 in IRS Compliance

Have you ever received bad advice? Oftentimes the bad advice we receive comes from those with good intentions. At a recent conference I was speaking at, I was surprised to hear from so many pastors who had recently received bad, or misinformed, advice regarding their churches and ministries from people who were trying to help.

What I have realized from traveling across the country and speaking with thousands of pastors and ministry leaders is that receiving bad advise is not as uncommon amongst pastors as one would like to think. The consequences of this can be quite costly.

For instance, many pastors and  church leaders are under the impression that their churches are required to file an annual Form 990 with the IRS. That is simply not true. Churches are exempt from having to file Form 990. This is the main reason why the Billy Graham Evangelistic Association (BGEA) applied for its tax-exempt status to be reclassified as an association of churches.

However, churches should not be too quick to dismiss ALL 990s. There is a type of 990 return that churches, and all nonprofit corporations, are required to file with the IRS should certain activities take place within the organization.

Let me explain.

The type of Form 990 churches are not exempt from

In all likelihood, the dreams you have for your church are bigger than your church’s checkbook. This is the case for many, if not all, pastors across the country. As a result, many pastors will begin to look for other avenues from which the church can generate additional income.

This might be done through activities such as:  

  • a church bookstore or coffee shop;
  • by selling ads in the church bulletin, on the church website, or in other church materials; and
  • by renting out church property and facilities.

While these are all great ways for churches to generate additional income to help further and carry out their mission, such activities may be considered an unrelated business, and the income generated from those activities are subject to an unrelated business income tax

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When your church earns $1,000 or more in gross income from an unrelated business activity, then your church must file Form 990-T. 

Before we discuss some of the specifics of Form 990-T, it is necessary for you to have a firm understanding of an unrelated business activity.

What is an unrelated trade or business?

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 an organization.
  • Section 513 defines the term “unrelated trade of 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.

Exceptions to unrelated trade or business activities

As you are becoming more familiar with what is considered an unrelated trade or business, you may be thinking of certain activities that your church is already conducting. 

Perhaps your church has a bookstore or coffee shop. Maybe your church operates a thrift shop from an extra room in your church and you are beginning to question whether this particular activity would be considered an unrelated trade or business. 

Well, even if an activity meets the above mentioned criteria of an unrelated trade or business, if any one of the following three exceptions are met according to section 513(a), that activity will not be considered an unrelated trade or business. The three exceptions are as follows:

  1. Substantially all the work in operating the trade or business is performed by unpaid volunteers.
  2. The activity conducted by your church is conducted primarily for the benefit of your members.
  3. The trade or business being conducted involves the selling of merchandise, substantially all of which has been received by your church as gifts or donations.

Additional exceptions you need to know about

We have discussed what constitutes an activity to be considered an unrelated trade or business, and we have examined three exceptions that negates an activity being considered an unrelated trade or business. In addition to these three exceptions, there are also some forms of income that are excluded from being considered unrelated business taxable income. 

Some types of income that are excluded when determining unrelated taxable income includes the following: 

  • dividends; 
  • interest; 
  • annuities; 
  • other investment income; 
  • royalties; and
  • rent from real property, e.g., buildings and land. (Rental income from personal property is not excluded.)

Rent received from debt-financed property

Section 514 of the tax code states that rental income your church receives from debt-financed property is considered unrelated business taxable income.

Section 514(b) defines debt-financed property as “any property which is held to produce income and with respect to which there is acquisition indebtedness at any time during the taxable year.” In other words, if your church’s building is mortgaged and you rent a portion of it out to another organization, then the rental income you receive is subject to unrelated business income tax. 

There is, however, an exception to this rule.

The 85 percent rule

Treasury Regulation §1.514(b)-1(b)(1) tells us if substantially all (85% or more) of the property is used for your tax-exempt purpose under section 501, then it will not be treated as debt-financed property for unrelated business income tax purposes. 

However, if less than 85% of the use of your debt-financed property is devoted to your tax-exempt purpose(s), then any rent received from your debt-financed property shall be treated as unrelated business taxable income.

Now that we have a better understanding of what is an unrelated trade or business and unrelated business income, let us take a look at how unrelated business taxable income should be reported. 

What churches and ministries need to know about filing Form 990-T

As previously mentioned, when a tax-exempt organization, including churches, derive income from an unrelated trade or business, then it must file an income tax return using Form 990-T. Keep in mind that filing Form 990-T is only required if your church receives $1,000 or more in gross income from an unrelated trade or business. 

Like other Form 990s, Form 990-T must be filed no later than the 15th day of the 5th month of your church’s fiscal year. In most instances this date will be May 15th. However, if, for instance, your church’s fiscal year happens to begin on July 1st and end on June 30th, then your Form 990-T would be due no later than November 15th.

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If you anticipate that your church’s unrelated business income tax liability for the year is going to be $500 or more, then you will need to use Form 990-W to calculate estimated taxes to be paid in quarterly installments. If your church’s fiscal year is aligned with the calendar year then your quarterly estimated payments should be made by April 15th, June 15th, September 15, and December 15th.

According to the instructions of Form 990-W, failure to pay the estimated tax when due may result in an underpayment penalty for the period of the underpayment. If your church ends up overpaying its estimated unrelated business income tax, then you may apply for a “quick refund” using Form 4466 if your overpayment is a least 10% of your estimated income tax liability for the year and it is at least $500.

When your church makes too much money from unrelated business activities

While I applaud ingenuity and thinking “outside of the box” when it comes to generating income to further the kingdom of God, 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 will be in jeopardy of being revoked.

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

If you have questions about your church 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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Raul Rivera

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