Are You Breaking This IRS Rule?

By Chaston Asbury

If you are a pastor that is currently receiving compensation, or you are planning to receive compensation from your church, pay close attention! 

Did you know that it is considered a conflict of interest for pastors to vote on their own salary? Or that it is also a conflict of interest for anyone on the board of directors that is related to the pastor to vote on the pastor’s salary? It’s even considered a conflict of interest for anyone currently receiving compensation to vote on someone else’s compensation.

This may be one of the most common mistakes churches and ministries make. And unfortunately, the IRS does not take this mistake lightly.

Find out if your church is breaking this IRS rule. 

If you are a pastor that is currently receiving compensation, or you are planning to receive compensation from your church, pay close attention! 

Conflicts of interest in the church

You have most likely heard of the term “conflict of interest,” but perhaps you are unfamiliar with how it relates to your church. The first step in improving your understanding of the relationship between conflict of interest and your church is to understand what situations create a conflict of interest when making a decision. 

In short, a conflict of interest occurs when an individual with a vested interest in the affairs of the church (board member, family of a board member, compensated individual, etc.) participates in a decision that may personally benefit him or herself or another individual with a vested interest in the affairs of the church. 

The Internal Revenue Service refers to such individuals with a vested interest in a tax-exempt organization as disqualified persons (see Treasury Regulation 53.4958-3). Understanding who is considered a disqualified person will help you prevent a conflict of interest situation from arising in your church. Disqualified persons can include: 

• Officers
• Directors
• Bishops
• Trustees
• Board members
• The senior pastor
• Relatives of officers, directors, bishops, trustees, board members, or the pastor
• Any individual on the board of directors that is receiving compensation from the church

The second step in improving your understanding of the relationship between conflict of interest and your church is to recognize a conflict of interest situation. 

Operating in compliance and above reproach

As a public charity, your church must be organized and operated exclusively for religious purposes. Furthermore, section 501(c)(3) states that no part of the net earnings of a public charity can inure to the private benefit of shareholders. 

This means that when a financial transaction occurs between a disqualified person and the church, great care must be taken to show that the interest of the church is put above the interests of the disqualified person, hence the conflict of interest.

Some possibilities of conflict of interest situations might include:  

• When a family member votes on the compensation of another family member (for example: if a pastor’s spouse were to vote on the pastor’s compensation).
• When a compensated individual votes on the compensation of another compensated individual.
• When a pastor votes on his or her own salary.
• Leasing, renting, or purchasing property from a board member. 
• Hiring a board member, their family, or a highly-paid staff member to do contract labor such as graphic designing, construction, financial services, and more.

So, does this mean that you cannot utilize the services of a board member if he or she owns a business that could help the church? Not at all!

In fact, Internal Revenue Manual (IRM) 4.76.3.11.2 states:

“There is nothing in [Internal Revenue Code] IRC §501(c)(3) to prohibit dealings between a charitable organization and its insiders (those in controlling positions) as long as those dealings are at arm's length, in good faith, and reasonable.”

This means that as long as you are acting in the best interest of the church, and can prove that you are doing so by establishing an arms-length agreement, then you’ve done your due diligence in mitigating the conflict of interest. 

Possible consequences

The IRS does not take conflict of interest lightly. In situations where there is a clear conflict of interest and decisions are made without addressing the conflict appropriately, the IRS can levy hefty fines and penalties upon all parties involved.

Without properly documented board meeting minutes in place, there is no legal or even written proof that the nonprofit correctly approved the financial arrangement. According to Treasury Regulation 53.4958-4(c)(1) and section 4958(a), even the smallest gap in documentation (i.e., board meeting minutes) could perhaps result in hefty excise taxes of up to 225%. 

The severity of these penalties needs to be respected. It is highly necessary for both churches and ministers to carefully consider how to approve and document any and all financial transactions.

How to prevent conflict of interest in your church

Understanding how to properly handle compensation and financial arrangements with disqualified individuals is critical to preventing a conflict of interest situation from arising.

Below are some key steps to keep in mind when creating financial arrangements that will help you approve them in a way that is IRS compliant and beneficial for all parties involved.

1. Take the proper measures to ensure that the compensation approved, or financial agreement created, is reasonable.

• The Internal Revenue Manual states that dealings between a nonprofit and its controlling members are okay as long as the agreements are reasonable. Proving reasonability is done by utilizing comparability data. 
• With regard to compensation, comparability data will include researching the pay of other staff with a similar position, credentials, organization income, organization size, geographic location, and more.
• When renting space from an individual on the board of directors, reasonability would be determined by researching the fair market value of similar properties in the area. The church can then enter into a rental agreement either at or below the fair market value.

2. Ensure that an arm’s-length agreement is established.

• An arm’s-length agreement means that the parties involved in formalizing the agreement are not under any strain by an outside party to sway the decision in that party’s favor.
• Sharing in the preliminary talks regarding the agreement, sharing what they will offer in the transaction, and sharing the benefit the board member is looking for is permissible. However, recusing themselves from the final vote regarding the compensation upholds the requirement that an arm’s-length agreement be established.

3. Properly document your board meetings.

• The board meeting minutes should include the comparability data and note that the disqualified individual recused himself or herself from the vote. 
• Make sure that the board meeting minutes are included in your corporate records and that the arrangements you establish do not violate the terms of the agreement.

4. Revisit the agreements annually. 

• All salaries and any other continuing financial arrangements must be revisited and re-approved each year, typically at the beginning of the fiscal year. Depending on your ministry’s budget and the financial health of your church, compensation may need to be adjusted each year. 
• In addition, when a service agreement is in place, the agreement may need to be revisited to account for changes in the fair market value of the service or changes in terms.

Make the best decisions for your church

Has your church made any decisions where a conflict of interest occurred but without taking proper steps to manage the conflict? If so, those mistakes can still be corrected. If you’re not sure, then give us a call at 877-494-4655. One of our specialists will be happy to assist you in finding out if a mistake was made, and if so, how to fix it. We’re dedicated to helping your ministry get right and stay right. 

If you are starting a brand new ministry and want to make sure that you are doing everything correctly, give us a call at 877-494-4655 and ask to speak with a church planting specialist. Or click the button below to have a specialist call you. 

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