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Your Church, Jan/Feb 2000
F I N A N C E & L A W
When Your Ministry Becomes Taxable
How to keep your new bookstore, childcare
center, or land rental from attracting IRS attention
John R. Throop
It seems innocent
enough and the right thing for your church to do: rent out some excess space
or land, open a bookstore, or start a childcare center. Then, praise God,
the ministry grows tremendously.
Your competitors may not be so pleased with your business operation. You
didn't think you were operating a business, but that's how bookstores
down the road view what you're doing. To them, you're a retailer
or service provider, not a ministry. And one big advantage you've got
over them is that your income is tax-exempt.
When Ministry Becomes
Business
Churches and religious organizations start revenue-generating operations
for two reasons. For some, the activity starts as a ministry and is intended
to remain that, but the ministry generates some nonvital cash flow. For others,
cash flow is critical to the success of the ministry.
The difference between the two types of cash flow is critical to the Internal
Revenue Service. The IRS has been paying closer attention to the business
operations of tax-exempt organizations to determine whether each activity
is an extension of the mission of the organization or a freestanding business
with income that should be taxed.
The line between the two can be fuzzy. "Most churches don't engage in
activities that would generate unrelated business income," says Chip Watkins,
an attorney with Webster, Chamberlain, & Dean in Washington, D.C. Yet
he cautions, "Larger churches, because of their complexity, may have commercial
activities unrelated to specifically religious or educational purposes. Or
there may be unrelated business income generated by certain dealing in
debt-financed land or rental of a debt-financed facility."
The IRS allows nonrelated business income. But income—as distinct from
donations—is taxable if it stems from an activity not "substantially related"
to the organization's activities and income. What does that mean? According
to IRS regulations, "substantially related" means the trade or business must
"contribute importantly to the accomplishment of the exempt purpose of an
organization."
The IRS applies three standards when considering whether the activities of
tax-exempt organizations are taxable. Income is presumed to be exempt from
taxes unless the activity
1. Is not substantially related to the organization's exempt purpose
or function,
2. Is a trade or business, and/or
3. Is regularly carried on.
In addition, the income must amount to at least $1,000 in a fiscal year.
So how should churches interpret these three points?
The unrelated business income (UBI) issue surfaced in the 1970s and 1980s
when nonprofit hospitals aggressively developed revenue-producing activities.
For example, the rehabilitation units of some hospitals had exercise equipment
standing idle at certain times of the day. Hospital administrators thought,
Why not open a community health club and charge membership fees?
For-profit club owners objected because the hospital's tax-exempt status
provided an advantage. In another example, colleges developed textbook depots
into full-service retail bookstores, rankling other booksellers who paid
taxes on their income.
While Watkins concedes that most churches don't undertake business ventures,
he says they do run the risk of IRS scrutiny—not because the IRS tax-exempt
section has become more zealous but because business people are complaining
more often. Those complaints can trigger an audit if there is probable cause
for suspicion that unrelated activities are occurring without taxation.
Case in Point
Here are some examples worth considering.
• Limited land lease. A growing church has bought land on the
edge of town, but there are no immediate plans to build. The land is rented
to farmers to finance the cost to acquire the land. The IRS allows a ten-year
tax-free period for this land use, but after five years "a solid plan for
development," as Watkins refers to it, must be presented and then completed
in the remaining five years. Following the ten-year period, the income from
the land is taxable, because a prudent person knows that churches are not
in the business of real estate development.
• No landlord privileges. A church builds a Christian education
and office complex and sells bonds or borrows money to finance construction.
To help pay for this debt-financed building, the church board rents space
to a community organization whose work is not directly related to the
church's mission and ministry. This rental income poses potential taxable
risks be cause a prudent and reasonable conclusion is that the church's
mission does not include being a landlord.
• No-go parking lot. A downtown church has an empty parking lot
during the week, while nearby parking garages are full. A business-minded
trustee sees an idle asset—parking spaces that could be leased on a monthly
basis. What's more, this income is passive—no one has to work to obtain
it. The income is taxable because the church's mission does not include
leasing space.
• Bookstore ministry. To provide members with helpful books and
study guides, church members open a small bookstore inside the facility.
The bookstore is open on Sundays and a few hours during the week while church
activities take place. Even though materials are sold at a profit, the income
is not taxable because the activity supports the church's educational
mission and operates primarily for the convenience of its members.
If a ministry operation contributes 50
to 80 percent of the church's income, it could
raise red flags for the IRS
• Bookstore business. A church bookstore becomes so popular that
it begins to stock a variety of books, cards, and gifts and establishes regular
hours for the public. It also moves to a location within the building that
has an outside entrance. It's a stretch to say that the church's
mission includes providing a retail outlet for Christian books and gifts.
Reasonable observers will deem this a business.
• Newsletter with ads. A church publishes a regular newspaper
that is sent to people's homes as an evangelistic tool. To pay for printing
and mailing costs, the church sells advertising. Eventually it realizes a
profit from ad sales. The newspaper may be part of the church's evangelistic
mission, but sponsorship income, or ad sales, could be taxed. The local
newspaper, which competes for the same advertising dollars and pays taxes
on that income, may complain.
How to Avoid an Audit
To avoid an IRS audit, church leaders need to take four steps:
1. Clarify your mission. A mission statement answers the question
"What kind of business are you in?" It provides a reference for board and
staff members to decide whether a particular activity or ministry is consistent
with the church's mission. Many churches have never developed a concise
and compelling mission statement. As a result, people assume that anything
goes as long as it can somehow be related to the gospel. A mission statement
is an important document to reference when questions arise.
2. Separate ministry from business. While there is no definitive rule
about when a church should consider separately incorporating a ministry that
becomes a business unit, many churches find that an activity becomes a business
when its liability risk becomes significant, and/or when the church board
discovers that this operation is gobbling up the time of staff members. If
a nonministry operation contributes 50 to 80 percent of the church's
income, it could raise red flags for the IRS. Note: It's possible to
form a subsidiary corporation that puts its profits back into the business
and into the church.
3. Take care in property use. Churches are most vulnerable on this
point. Be very careful when considering rental income to help finance a
construction project. Make sure building plans move ahead without undue delay.
If your church receives land as a gift, liquidate it unless a ministry, like
a church camp, will be developed on the property within ten years.
4. Retain a skilled attorney. "Any larger church must have someone
acting as general counsel who is familiar with the activities of the church,"
Watkins says. If a church plans to undertake a nontraditional revenue-producing
activity, church leaders should first come to grips with the business vs.
ministry issue. "There often is a way to structure the church's activity
for exempt purposes without generating in come as a trade or business," Watkins
says. After all, it's wiser for churches to focus on the business of
making disciples rather than making a profit.
John R. Throop is a management consultant based in Peoria, Illinois,
and is vicar of Christ Church Limestone, near Peoria. Contact him at
jthroop@concentric.net.
Copyright © 1999 by the author or Christianity Today International/Your
Church Magazine. Click here
for reprint information on Your Church.
January/February 2000, Vol. 46, No. 1, Page 75
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