Young Church Forgets to File Tax Return, IRS Penalties Pile Up!

By Raul Rivera

It was an hour-long conversation. I was talking to a pastor about his status as a church. He was upset because, having heard in the past that churches were exempt from needing to file Form 990, he had for the past two years not filed a tax return, only to realize now that he was required to file the forms since his church had actually been given ministry status at the time of their 501(c)(3) approval. Now he was having to come to terms that his church had to file two years of late 990 tax returns and pay large, late filing fees.

Here is how that happened.

A tale of caution for all churches

Pastor X started his church in January of 2009. At the time he started it, there were about 15 people happily meeting in a home. By around June of that same year they were at 25 and in the process of applying for their tax-exempt status with the IRS.

As part of that process, they received a letter from the IRS stating that the IRS could approve the application and grant them 501(c)(3) status as a religious ministry. This offer seemed good to both the pastor and his board of directors, whom had all met to discuss the IRS agent's recommendation. They sent a reply to the IRS stating their wish to accept the recommendation, and within two weeks they had their 501(c)(3) approval letter.

(Recommended reading: "Does a Church Need to be 501(c)(3) Approved?")

Everything seemed OK because the letter stated the following:

Based on information supplied, and assuming your operations will be as stated in your application for recognition of exemption, we have determined you are exempt from federal income tax under section 501(a) of the Internal Revenue Code as an organization described in section 501(c)(3). 

The letter also stated:

We have further determined that you are not a private foundation within the meaning of section 509(a) of the Code, because you are an organization described in sections 509(a)(1) and 170(b)(1)(A)(vi).

Though they were not sure what all the legal jargon really meant, they knew one thing; they were officially tax exempt and a public charity. Now, they could apply to the state for their sales tax exemption.

Be vigilant over the details

The problem that Pastor X experienced is common when churches use inexperienced volunteers to prepare their 501(c)(3) application. Though they are well intentioned, they do know that the road to tax exempt status is filled with many potential pitfalls.

(Recommended reading: "How to Start a Church the Right Way")

At the time that Pastor X's church applied, the IRS agent reviewed their application and challenged their status as a church because they were a small group. Though the law and the courts do not allow the IRS to use size as criteria, many agents ignore it. It is in these moments that having someone with experience is vital. 

Had Pastor X had a good consultant, he would have never accepted the agent's recommendation and would have continued to seek their 501(c)(3) approval as a church and not as a ministry.

There is a difference

The Internal Revenue Code grants 501(c)(3) status to many types of organizations. These types of organizations range from churches and educational entities, to humane societies, clubs and religious ministries. Each one of these is defined in the tax code.

Churches are defined in section 170(b)(1)(A)(i), while ministries are defined in section 170(b)(1)(A)(vi). Each one of these has a significant impact on the future of the organization. 

Current law exempts churches from having to file 990 tax returns, but requires ministries to file annually. The late fee is $20 per day for each day the return is late. The maximum penalty is $10,000, or 5 percent of the organization's gross receipts, whichever is less. The penalty increases to $100 per day, up to a maximum of $50,000, for an organization whose gross receipts exceed $1,000,000. Pastor X had two late tax returns with late penalties  $2,850.00 and $4,700.00.   

Every church is a ministry, but not every ministry is a church

I often get asked the question, "What is the difference between a church and a ministry?"  The question is simple but the answer is complicated. For legal and tax purposes the best way I can answer it is by saying that every church is a ministry, but not every ministry is a church.

The courts have struggled with the concept of church.  In American Guidance Foundation v. United States, the court described church to mean that at " . . . a minimum, a church includes a body of believers or communicants that assembles regularly in order to worship."

As you can see, by the court's point of view a church has at its minimum a congregation of believers. However, that does not prevent a church from having ministries. In every occasion where a church has had ministry outreach, the IRS and the courts have ruled in favor of the church.

Where the problem lies

As with Pastor X, the big problem lies in how the IRS views your application for 501(c)(3) status. Though Pastor X had a congregation, his application for 501(c)(3) status was very weak in its narrative and Schedule A. His inexperience with IRS trends and knowledge of the law resulted in his church receiving a 501(c)(3) approval that appeared to be correct, but in fact was not a true reflection of his church. For now, he will have to file two years' worth of late tax returns and a current year tax return plus pay significant penalties.

Check your 501(c)(3) letter

Now is a good time to pull out your 501(c)(3) approval and read it. Look at the upper right hand corner where it says public charity status. Does it say "170(b)(1)(A)(i)", or does it say "170(b)(1)(A)(vi)?

Now take a look below where it says "Form 990 required:" does yours say "Yes" or "No?"  If your letter says "170(b)(1)(A)(vi)" and "yes", then you have been classified as a ministry.

(Recommended reading: "What To Do When It's Time To Reclassify Your Ministry")

What if I am a new and small church?

Every year many pastors and leaders attempt to do the 501(c)(3) application alone. Currently, 68% of these applications never get approved because the IRS questions that follow the application are so frustrating and overwhelming to the applicants that they just give up.

Every year, we assist hundreds of churches with their 501(c)(3) status to ensure that never happens. We also preemptively answer many questions that are not on the application. 

It is very important to be attentive to the details of the application. We know that what we say in one section of the application impacts all the other sections. We also make sure that we clearly and concisely make a strong case that you are indeed a church with a congregation. If you need help, give us a call; I am certain we can assist you with this important next step for your organization!

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