How to Prevent an IRS Audit

By Raul Rivera

“If I were you, I would never get the 501(c)(3). I heard that if you do, the IRS can audit you and can also restrict what you preach.”  These were the words of advice an elderly pastor gave to a younger pastor. In the many conversations I have had with pastors, I have occasionally heard a pastor say, “Our church is a free church, not a 501(c)(3) church”. When people use the term “free church”, they usually do so with the thought that they are intrinsically separated from government oversight. Such churches rely on the term “free church” so as to prevent any kind of IRS audit and to prohibit any type of government intervention regarding church matters. This, however, is a misguided thought process.

The IRS cannot simply knock upon the doors of a church with the intention of performing an audit. There are provisions and guidelines established within the Tax Code that set parameters on the reach of the IRS in regards to church audits.

Because of this common misunderstanding amongst pastors and church leaders, I want to use this post as a teaching tool and a source of encouragement to you and your church. In this post, I am going to teach you how to prevent an IRS audit of your church. But first, in order to understand how to prevent an IRS audit, we need to understand how an IRS audit can begin.

How an IRS audit can begin

Internal Revenue Manual 4.76.7.4 defines a church tax inquiry “as any inquiry to a church…that serves as a basis for determining whether the organization qualifies for tax exemption as a church, or whether it is carrying on an unrelated trade or business or otherwise engaged in activities subjected to any IRC tax.”

Furthermore, section 7611 of the Internal Revenue Code gives guidelines as to how the IRS may begin a church tax inquiry. According to section 7611, the IRS may begin a church tax inquiry only if:

• an appropriate high-level treasury official reasonably believes (on the basis of facts and circumstances recorded in writing) that the church is not exempt, by reason of its status as a church, from tax under section 501(a), or that it may be carrying on an unrelated trade or business or otherwise engaged in activities subject to taxation; and

• the IRS sends the church a written inquiry notice containing an explanation of 1) the concerns which gave rise to such inquiry, 2) the general subject matter to such inquiry, and 3) the applicable administrative and constitutional provisions with respect to such inquiry, and the provisions of the title which authorize such inquiry.

In essence, we see that in the event of a church audit, the primary goal of the IRS is two-fold: to determine whether the church is operating in a manner consistent with its purpose and section 501(c)(3), and to determine whether the church is conducting any unrelated business activities. (For more information on unrelated business activities, click here.)

Before we look at how you can prevent an IRS church audit, we need to first understand what may help the IRS establish “reasonable belief” in order to begin the process of a church audit.

Reasonable belief

Now, there are several things that an IRS high-level treasury official can rely upon to establish “reasonable belief”, such as:

• Newspaper or magazine articles or ads involving the church;
• Television or radio reports involving the church;
• Church websites;
• Voter guides created and/or distributed by the church;
• Documents on file with the IRS, such as Form 990-T (used to report unrelated business income tax);
• Records concerning the church in possession of third parties or informants; and
• Letters from current or past church members or board members.

Now that we are aware of the parameters and guidelines that the IRS must follow in the event of a church audit, and that which may help establish “reasonable belief”, let us look at what you can do to help prevent an IRS audit from happening to your church.

Preventing an audit

The one word that best describes what churches need today in regards to their records is compliance. The rules and regulations that govern the way churches conduct business has dramatically changed throughout the years. The way that churches once did business and maintained records is no longer relevant. 

Each week, we have the honor and privilege of speaking with hundreds of pastors and church leaders across the country who are in the same boat that you currently find yourself in, with regards to the administrative aspects of church. These pastors and church leaders are also concerned with the current state of their church records, and they are aware that their church records are far from being perfect. Although it is perfection that we often seek, it is seldom achieved. If this also describes your situation, do not worry. 

Below are five steps for you and your church to take that will help to prevent an IRS audit on your church.

1. Maintain board meeting minutes

It is often assumed that the most important records for a church to maintain are its financial records. Although, especially for stewardship purposes, it is important for churches to maintain good financial records, it can be argued that board meeting minutes are the most important records for churches to properly maintain. 

Board meeting minutes serve as the official documentation of the corporate acts of your church. Without board meeting minutes, your church cannot show proof that the church properly approved corporate actions such as the appointment of board members, the adoption of your bylaws and policies, and the approval of salaries. 

As a nonprofit organization, it is imperative that all corporate actions of the church be properly documented in well maintained board meeting minutes.

2. Document all salaries and compensation

Salaries, and compensation in general, should be maintained with diligence. It is necessary for all salaries to be approved annually, by the board of directors, during a properly called board meeting. Additionally, salary compensation agreements should include, but are not limited to, the monetary amount to be paid, what the job entails, the number of hours required, and comparability data for other similar positions. 

If a guest speaker comes to speak at the church, then be sure to treat any cash or offering given to him/her as an honorarium. This means that the church should obtain Form W-9 from the guest speaker and a 1099 should be given to the speaker if he/she receives $600 or more from your church in one year.

3. Review your church’s activities

As we saw earlier in this post, one of the purposes of the IRS during a church audit is to determine whether the church is operating in a manner that is consistent with its purpose and section 501(c)(3). Therefore, it is important to review the activities of the church in order to make that determination. When reviewing the activities of the church, you will want to make sure that each ministry and department directly relates to the purpose of the church. 

If, through your review of church activities, you determine that an activity may be considered an unrelated trade or business activity, such as a bookstore or coffee shop, then you will want to consider starting a for-profit arm of the church. (For more information on a for-profit arm, click here.)

4. Review your church’s printed and publicized materials

Since the IRS can use any printed or publicized material as a source of “reasonable belief” to begin a church inquiry, you will want to be sure to keep a close guard on such materials. This also includes your church’s website. It is best not to include any type of advertisements on your church’s website, which, depending on the facts and circumstances, may be considered an unrelated business activity, and could potentially jeopardize your church’s tax-exempt status.

5. Review all of your church’s internal governing documents

There are several documents that your church must review and maintain on a regular basis, such as:

• The church’s articles of incorporation, amendments, annual reports, charity registration, IRS approval letter, and any letters regarding the church updating its public record.
• The church’s bylaws.
• The church’s written doctrines.
• The church’s policies and procedures. (You will want to make sure that your church has a conflict of interest policy, accountable reimbursement policy, and a benevolence policy.)
• Corporate contracts such as leases and titles to property.
• Accounting and financial records.
• Current and accurate membership records.

Now, perhaps you are looking at these five steps and you realize that your church might not do so well in the instance of an IRS audit. I want to encourage you not to worry. The best way to move forward is to correct what was done in the past and then move forward. This can be done by performing an internal church audit of all church records.

To help you with this process, we have a resource called Audit within our Management Suite™. This resource includes 53 simple steps that will help you and your church along in the right direction. 

Conclusion

If you are a pastor reading this, you understand that the administrative aspect of church is an important key to leading a healthy and vibrant church, almost as much as is the spiritual aspect of church. But perhaps you just do not know where to begin. 

At our conferences, we teach that you need to StartRIGHT to StayRIGHT, and if you did not StartRIGHT, you cannot StayRIGHT unless you GetRIGHT. I want to invite you to one of our upcoming conferences for a day of learning, revelation, and rejuvenation. 

Be encouraged in the fact that you are not alone, and you will prevail in this matter, because you are the head and not the tail!

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