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What You Need to Know About Your Pay, Part 2

By Raul Rivera

In Part 1 of this series we spent some time discussing the definition of compensation. We delved into the fact that ministerial compensation drastically differs from that of “normal” compensation, for tax purposes. We also examined the misconception that many pastors believe they are exempt from having to pay income tax on income received as a minister. Lastly, we discussed what ministerial compensation encompasses. But now the question we must ask, and one that you must understand, is, “How do we determine reasonable compensation for the pastor?”

Whenever money or one’s salary amount gets brought up in the same sentence at church, people begin to get uncomfortable. Some ministers even go so far as to say that they do not want to know anything about, or have anything to do with, the church’s finances, preferring to “keep their hands clean” and only worry about spiritual matters. However, as respectable as that may seem, it is simply not a luxury pastors and church leaders can afford in the world of church compliance today.

In Part 2, I want to spend some time explaining how you and your church can establish a reasonable, pastoral compensation without worrying whether or not your church is operating compliantly. I will explain to you what presumption of reasonableness is, and we will also examine 3 points you should implement when determining not only the pastor’s salary, but also anyone who receives a salary from the church. But first, let us take a brief look at what section 4958 of the Internal Revenue Code says about ministerial compensation.

Section 4958 requirements

Under section 4958, the IRS has been given the ability to assess intermediate sanctions on churches and other nonprofit organizations that do not properly approve and document compensation. Many believe that section 4958 was created to prevent compensation packages from being too excessive. However, that is simply not the case.

This section of the Internal Revenue Code was created to prevent private inurement from taking place, and to ensure that compensation packages are properly documented and reported to the IRS for tax purposes. According to Treasury Regulation 53.4958-4(c)(1), even the smallest gap in documentation could perhaps result in stiff excise taxes of up to 225%. Because the severity of these penalties needs to be respected, both churches and ministers should carefully consider how to determine and document compensation. To do that, we need to understand what the presumption of reasonableness is. Then we will look at 3 points you should consider and implement before paying or receiving compensation.

Presumption of reasonableness

Unfortunately, with regards to taxation, you are generally guilty until proven innocent. However, Treasury Regulation 53.4958-6 provides us with an exception to this rule. The regulation considers a situation in which there is the presumption that compensation is reasonable. There are several criteria that allow compensation to be considered reasonable by default and that force the IRS to prove otherwise. These are found in Treasury Regulation 53.4958-6(a), which states,

“(1) The compensation arrangement or the terms of the property transfer are approved in advance by an authorized body of the applicable tax-exempt organization (or an entity controlled by the organization within the meaning of §53.4958–4(a)(2)(ii)(B)) composed entirely of individuals who do not have a conflict of interest (within the meaning of paragraph (c)(1)(iii) of this section) with respect to the compensation arrangement or property transfer, as described in paragraph (c)(1) of this section; (2) The authorized body obtained and relied upon appropriate data as to comparability prior to making its determination, as described in paragraph (c)(2) of this section; and (3) The authorized body adequately documented the basis for its determination concurrently with making that determination, as described in paragraph (c)(3) of this section.”

In essence, the compensation is considered reasonable if a balanced board of directors uses comparable salaries, documents those comparable salaries, and records everything in board meeting minutes approving the salary, and it does all of this before making any payments. The presumption of reasonableness is important because it relieves the church, its board, and the individual receiving the benefit from having to prove that the benefit was one of reasonableness. Let us next look at how you can determine and approve reasonable compensation when applying these three points.

1) Is your board “balanced”?

Although the term “balanced board” is not actually used within section 4958, we can gather that it is implied within Treasury Regulation 53.4958-6(C)(iii). It is this portion of the Code that requires nonprofit organizations to have a conflict of interest policy. Within Treasury Regulation 53.4958-6(C)(iii), we see three things:

  1. That no individual can vote on his/her own compensation or the compensation of a spouse or other related individual;
  2. That no individual can vote on the compensation of someone with whom he/she has a close working relationship; and
  3. That no individual already receiving compensation from the church can vote on the compensation of another individual.

From this, we are able to gather that your board of directors must be balanced. In short, this means that there must always be a majority of unrelated and uncompensated individuals serving on your board of directors in order to properly approve one’s compensation. Next, let us discuss the second point you should implement when determining one’s compensation.

2) Salary comparability

As previously mentioned, and as discussed in Treasury Regulation 53.4958-6(c)(2), there are several different factors to consider when attempting to determine reasonable compensation. One such way is using salary comparability data. The most common factors to consider when using such data are as follows:

  1. Organization income: Organization income is generally the key concern. The organization’s income heavily dictates the amount that can be paid to its employees.
  2. Geographic location: Another key criteria is geographic location because incomes vary greatly from one location to the next. This impacts not only the amount needed by the individual, but also the amount donated to the organization.
  3. Organization size: Depending on the type of organization, this can mean congregation size, or the number of employees, or the number of customers (for lack of a better term). Organizations of similar size can be used for comparability data.
  4. Functionally equivalent position: As we know, not all employees in an organization receive the same pay. We also know that a position of a certain title in one company may be very different than a position under the same title within a different company.
  5. Individual’s qualifications: Income levels in all sectors vary based on qualifications such as time in the industry, past experience, applicable knowledge, courses/degrees completed, and recommendations/endorsements. Individuals with similar qualifications can be used in obtaining comparability data.

3) Adequate documentation

This third point that you must implement when determining reasonable compensation is adequate documentation. This is simply referring to board meeting minutes. In addition to holding a board meeting and having any compensation approved by the board of directors, any compensation must also be documented in board meeting minutes. Without board meeting minutes showing that compensation was approved by a balanced board of directors, it is as if the meeting never happened and the compensation was never approved. Therefore, without adequate documentation (board meeting minutes) that compensation could potentially be liable to the excise taxes of up to 225% that we discussed earlier in this post.

Let us help!

I realize that compensation is one of those sensitive topics amongst churches and pastors. I am a firm believer that pastors and ministers should be adequately compensated for their services as long as the church is able to afford it. But, I also know that compensating pastors, and any church employee for that matter, needs to be done correctly. The potential penalties for doing it incorrectly are far too great.

That is why we have a Minister’s Compensation Package service. I want to encourage you to give us a call at 770-638-3444 if you feel like you need any assistance, whatsoever, regarding compensation agreements. It would be our pleasure to serve both you and your church.

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