Minister fined 200% Tax Penalty

By Raul Rivera

The following story is grounded in facts from a recent legal proceeding. In the interest of confidentiality and creative adaptation, the names of the entities and individuals involved have been altered, given the case's recency.

Reverend Miguel Torres and his wife, Ana Torres, were the embodiment of dedication to those in need. In 1998, Rev. Torres founded the Beacon Health Clinic as a haven for those with medical needs. They soon applied for and received 501(c)(3) status.

As time passed, Ana Torres assumed various roles, ranging from board member to financial overseer, maintaining a devout presence at every board meeting. However, by 2014, during an IRS audit, the church's accounts showed a disparity. Despite the absence of formal contracts, the couple received compensation not documented in the church's formal records—a detail that remained unnoticed until an IRS audit uncovered it.

The IRS discovered a pattern of compensation payments to Ana Torres—biweekly checks totaling $27,000 and monthly amounts totaling $88,000. While the amounts may have been justifiable as reasonable compensation, the absence of specific documentation meant otherwise according to the law. This lack of documentation and reporting brought section 4958 into sharp focus, identifying these payments as excess benefits—a severe infraction for tax-exempt entities. At least five measures could have prevented the heavy fines imposed on them, which I will detail later.

1. She did not receive a W-2 form from the church.
   
   
2. She was not issued a Form 1099-NEC.
   
   
3. She did not report the income on her Form 1040.
   
   
4. There were no minutes to indicate that the board approved the compensation.
   
   
5. She lacked a written compensation agreement.

Beacon Health Clinic faced the wrath of Section 4958’s sanctions, levied heavily upon Ana Torres. She incurred a first-tier penalty of 25% on the excess benefit, amounting to $32,500, and a crushing second-tier tax of 200%, tallying up to $260,000, a sum designed to be punitive if corrective action wasn't taken promptly.

The IRS's imposition of additional taxes under sections 6651(a)(1) and (2) for failing to file Form 4720, amounting to $7,313 and $5,525, respectively, painted a grim picture for the future. The once-flourishing clinic's lifeblood was drained, not by malice, but by a lack of knowledge about what should have been done.

The IRS's decisive revocation of the clinic’s tax-exempt status marked the final blow to their legacy. The importance of meticulous compliance and the severe implications of disregarding Section 4958 are lessons learned too late for the Beacon Health Clinic.

Another example is the improper use of church property

I will keep this example brief. At Lighthouse Gospel Church, Pastor Thompson was provided with a church vehicle to support his pastoral duties, including home visitations and community outreach. Unfortunately, the church did not implement a policy to monitor personal versus business use of the vehicle. Consequently, Pastor Thompson's personal use of the vehicle remained unrecorded and unreported as a taxable benefit, an issue that surfaced during an IRS audit. This oversight led to it being classified as an excess benefit transaction, imposing financial burdens in the form of taxes and penalties on both Thompson and the church board members. This case underscores the importance of maintaining stringent policies and meticulous records for church property usage to prevent unintended tax violations and financial liabilities.

Pastors must maintain a detailed mileage log to comply with IRS regulations and ensure accurate record-keeping for business mileage. This log should document each trip's date, purpose, starting point, destination, and total miles driven, calculated using the current IRS standard mileage rate of $0.67 per mile for the first half of 2024.

Full compliance also necessitates tracking personal miles. Any vehicle usage not directly tied to church activities, such as personal errands or family trips, must be clearly documented and declared as a fringe benefit. These personal miles are then reported as a taxable benefit on line 12 of the W-2 form. For instance, if Pastor Thompson drives the church vehicle for 300 personal miles, the church is responsible for reporting an additional taxable benefit of $201 (300 miles * $0.67 per mile) on his W-2 form. Adhering to these practices allows pastors to transparently separate church-related service from personal use, thereby upholding tax law compliance and avoiding the severe consequences of Section 4958.

One last example: IRS blesses a Pastor’s $200,000.00 signing bonus

In Lonestar, Texas, Shepherd's Bounty Church boasts a diverse congregation of 400, including children. Renowned for its many high-net-worth members, the church sought a pastor whose vision and fervor matched theirs. Their search led to Pastor David Martinez, a charismatic leader with a remarkable track record and high demand for his pastoral services.

Recognizing his value and potential impact, the church board presented a generous offer. They proposed an annual salary of $350,000 for Pastor Martinez, enhanced by an attractive package of insurance and retirement benefits. Additionally, they offered a $200,000 signing bonus and a brand-new car worth $100,000. Thus, his total first-year remuneration amounted to $550,000 in cash, not including the value of the benefits package or the vehicle.

Such an offer might typically prompt scrutiny from the IRS, given the strict regulations on compensation within tax-exempt organizations. However, as Pastor Martinez negotiated his contract before becoming an 'insider' and 'disqualified individual,' Section 4958's rules on excess benefits did not apply, affording him a first-year grace period.

Entering his second year, the church's board validated his salary as reasonable, given the church's substantial financial resources. A W-2 form was properly issued to reflect his compensation and benefits. Pastor Martinez's story with Shepherd's Bounty Church highlights the critical role of informed governance, savvy negotiation, and adherence to IRS regulations in ensuring equitable and lawful compensation in churches and ministries.

How should a pastor be paid?

These above scenarios demonstrate that the IRS is not solely concerned with excessive compensation for pastors; rather, it seeks to ensure that all compensation is correctly documented as articulated in Section 4958 of the tax code. A significant aspect of their review focuses on the adequacy of documentation. I saw a case in which a pastor in New York making 20,000 per year was ruled an excess benefit transaction because it was not adequately documented. As previously noted, there are at least five ways to avoid the penalties associated with section 4958. Arguably, the most effective method is establishing a self-renewing compensation agreement. Such an agreement continues year after year without requiring annual board reauthorization. It's important to note that this approach applies to both full-time and part-time pastors, ensuring compliance is maintained across all levels.

Conclusion

In conclusion, I want you to consider a practical approach to compensation and compliance. If you anticipate receiving any form of compensation from your church or ministry in the forthcoming year, now is the best time to establish a compensation agreement. Proactive preparation allows for thoroughly contemplating the various options available to ministers or church staff. Addressing these matters now, rather than postponing until the need arises, affords you ample time to consider different scenarios, seek guidance, and clarify any uncertainties. This forward-thinking strategy ensures that when the moment comes to activate your compensation agreement, you are fully prepared and informed, having laid a solid foundation for compliance and peace of mind.

At StartCHURCH, our specialists walk pastors and leaders through creating compensation agreements. Our Compensation Agreement Service shows you multiple scenarios so that you can choose the options that work best for you and your church. Give us a call at 770-638-3444, and let us help you today.

1. Ononuju v. Comm'r, T.C. Memo. 2021-94, 7 (U.S.T.C. Jul. 26, 2021)

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