What You Need to Know About 501(c)(3) Compliance

About once a week, a client asks me, “What are the benefits of being a 501(c)(3) for our church?” I gladly reply with a list of benefits from protection for donors to eligibility for state and local taxes and an attractive option for those looking to support charitable causes. 

Interestingly, I rarely hear the question, “What happens if I don’t comply with IRS requirements?” So I’d like to make a bold statement and say that this question is more important than the question about benefits. Here’s why: without compliance, the available benefits don’t matter. 

Now, this statement shouldn’t scare us. It should empower and encourage us to know the requirements of 501(c)(3) status so that we can protect our and our donors’ investment in the work we are building for God. 

So let’s get into it. Let’s discuss what could be at stake if we don’t comply with the IRS’ requirements for tax-exempt churches. 

What does non-compliance look like?

As tax-exempt 501(c)(3) organizations, there are four fundamental requirements with which churches must comply: 

1. Conduct charitable and religious activities defined in IRC Section 501(c)(3).

2. Never operate for the personal benefit of board members or those closely related to board members by family or business association.

3. Not dedicating a substantial amount of time and resources to lobbying. 

4. Not supporting a political candidate. 

Violating any of these basic requirements can result in a loss of tax-exempt status. Here are examples of what it looks like to violate these requirements. 

• Operating a business in competition with other local businesses as an activity of the church. This can look like running a restaurant, a car wash, or a graphic design business. 

• Paying for the pastor’s personal needs without prior board approval. 

• Compensating a board member without following a Conflict of Interest Policy. 

• Operating without a properly established Board of Directors.

• Openly supporting a local or national candidate for an office from the pulpit.

• Dedicating more than 15% of our time and resources to lobbying for legislation.

These are just a few examples, but do you get the picture? These activities are outside the realm of what a 501(c)(3) is permitted to do. Like businesses, charities also have specific requirements to follow to enjoy tax exemption benefits. Now let’s take a deeper look at what’s at stake when we don’t comply with these fundamental rules.

Penalty 1: Loss of Protection for Donors

What makes 501(c)(3) organizations unique is that they are one of the few tax-exempt entities to which donations are tax-deductible. There are many tax-exempt organizations like commerce clubs, political organizations, co-ops, and more! But a contribution to a 501(c)(3) has the added benefit of being able to claim a deduction for that donation. 

This is because 501(c)(3) organizations exist for public benefit. Therefore donations from the public to support them are considered deductible as well. 

When an organization’s 501(c)(3) status is revoked, the donations to that organization automatically are no longer tax-deductible. In some circumstances, donors who claimed tax deductions might even be required to reimburse the IRS for the deductions claimed. 

Penalty 2: Fines, Fines, and More Fines

When a church is found to have given excessive benefits to an insider such as a board member, highly compensated employee, the family of a board member, or business partner of a board member, the person who received that excessive benefit will be fined 25% of the excess benefit. 

Furthermore, the board members can be charged 10% of the excess transaction individually to comply with the excess benefit transaction. Not only that, but the IRS can assess a 200% penalty if the mistake is not corrected in their allotted time! 

For perspective, let’s say that fair market value for a full-time pastor of a 200-member church is $60,000 annually. The board of that church decides that it’s not enough and pays the pastor $20,000 in undocumented compensation “under the table.” If that church is audited and the indiscretion is caught, the pastor who received that transaction will be fined 25% of that $20,000, which would be $5,000. Then, each board member who complied with the action could be fined $2,000! Not an easy price to pay!

Penalty 3: Loss of Tax-Exempt Status

A church can lose its tax-exempt status by failing to comply with 501(c)(3) requirements. This comes at a cost to its community, its members, and the mission it is meant to fulfill for God. 

The reality is that there are simple steps churches can take to reduce the likelihood of revocation of their tax-exempt status. These steps include: 

• Properly establishing the corporation

• Properly establishing the board of directors

• Following basic policies like the Conflict of Interest Policy and Accountable Reimbursement policy to comply with compensating properly

• Not regularly conducting business through the church but setting up a For-Profit Arm

First published on StartChurch.com. Used by permission.