Stop breaking an IRS Regulation Today

By Justin Upchurch

While meeting with his mentor, Pastor Larry was explaining that because of the growth his church had experienced this year, his church was finally able to hire some much-needed help—a full-time associate pastor and a part-time administrator.  

Pastor Larry continued to explain that he felt like he was finally getting a good grasp on this “church planting thing.” 

But then his mentor asked him one question that stopped him in his tracks. 

“Did you vote on the salaries of these new church employees?”

Pastor Larry’s mentor went on to explain that because of something called “conflict of interest,” Pastor Larry was unable to vote not only on his own salary, but also on the salaries of other individuals within his church.

His mentor went on to further explain conflict of interest, and here is what Pastor Larry learned that day. 

The relationship between conflict of interest and your church

You have most likely heard 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 recognize a conflict of interest situation. 

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

The Internal Revenue Service (IRS) refers to individuals with a vested interest in a tax-exempt organization as disqualified persons (see Treasury Regulation 53.4958-3). This includes the following: 

• Officers;
• Directors;
• Bishops;
• Trustees;
• Board members;
• Pastor; and
• Relatives of officers, directors, bishops, trustees, board members, or the pastor.

Understanding who is considered a disqualified person will help you to prevent a conflict of interest situation from arising in your church.

Examples of conflict of interest situations

As a public charity, your church must be organized and operated exclusively for charitable 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 those with substantial control in the corporation; hence the conflict of interest.

Some examples of conflict of interest situations include:  

• When a family member, such as the pastor’s wife who may also serve on the board, votes on the compensation of another family member.
• When a compensated individual votes on the compensation of another compensated individual.
• When a pastor sets his/her own salary.
• Leasing property from a board member. 
• Hiring a board member, his/her family, or a highly-paid staff member to do contract labor such as graphic designing, construction, financial services, and more.

Does this mean that you cannot utilize the services of a board member if he/she owns a business that could help the church?

It does not mean that 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, then you will not have to worry about a conflict of interest situation occurring. 

What happens when a conflict of interest situation occurs?

The IRS does not take conflict of interest situations lightly. In such situations, the IRS can levy hefty fines and penalties upon all parties involved.

Unless properly documented board meeting minutes are in place, there is no legal or even written proof that the non-profit 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, and both churches and ministers should carefully consider how to determine and document any and all financial transactions.

How to prevent a conflict of interest situation in your church

Understanding how to properly handle compensation and financial arrangements with disqualified individuals is key 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.

Remember that 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 regards to compensation, comparability data will include researching the pay of other staff with a similar position, credentials, organization income, organization size, and more.

2. Ensure that the agreement is done at arm’s-length.

The at-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.

Because the board member is the one with whom the conflict of interest is present, the board member should recuse himself/herself from the final vote.

Sharing in the preliminary talks regarding the agreement, sharing what he/she will offer in the transaction, and sharing the benefit the board member is looking for is permissible.

However, recusing himself from the final vote regarding the compensation upholds the requirement that an at-arm’s-length agreement be established.

3. Properly document the board meeting approving compensation.

The board meeting minutes should include the comparability data and note that the board member recused himself/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. If it is an on-going relationship, revisit the agreement annually. 

All salaries and any other continuing financial arrangements must be revisited and re-approved each 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. 

For instance, if your church utilizes the services of a payroll company for an annual fee, you should analyze any aspects of the service that could change the payment arrangements and make sure that everything is in the best interest of your church.

It is never too late to GetRIGHT

After reading this, some of you may have realized that you need to GetRIGHT. It’s not too late!

For those of you who are just starting your church, I encourage you to make sure that you StartRIGHT.

If you are not sure what this means or looks like for your church, I invite you to attend one of our Ultimate Church Structure Conferences.

If you simply have questions and need help being pointed in the right direction, give us a call today at 877-494-4655 and we’ll be glad to help.

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