Tax Guidelines for Churches and Religious Organizations

Churches and religious organizations play a vital role in communities, providing spiritual guidance, charitable services, and support. Understanding the tax regulations governing these entities is essential for maintaining compliance and financial integrity.

Tax-Exempt Status Criteria

Obtaining tax-exempt status under Internal Revenue Code (IRC) Section 501(c)(3) exempts churches and religious organizations from federal income tax. To qualify, these entities must be organized and operated exclusively for religious, educational, scientific, or other charitable purposes. The organizational test requires founding documents, such as articles of incorporation or bylaws, to clearly state the entity’s exempt purpose. The operational test ensures activities align with the stated mission, and no part of net earnings benefits private individuals or shareholders.

Maintaining tax-exempt status also requires adherence to the prohibition against political campaign intervention. Churches and religious organizations cannot participate in political campaigns for or against candidates. Violations may result in losing tax-exempt status. Limited lobbying is permitted, but it must not constitute a substantial part of the organization’s activities. The IRS evaluates lobbying through a “substantial part” test, making thorough documentation of such activities essential.

Compliance with public policy is another requirement. Activities must not be illegal or violate established public policies, such as engaging in discriminatory practices. While churches are automatically considered tax-exempt and not required to file Form 1023, filing can provide additional benefits, including public recognition of their tax-exempt status.

Unrelated Business Income Tax (UBIT)

Churches and religious organizations that generate income from activities unrelated to their religious or charitable purposes may be subject to the Unrelated Business Income Tax (UBIT) under IRC Section 511. UBIT ensures tax-exempt entities do not gain an unfair advantage in commercial activities.

Three criteria determine if income is subject to UBIT: it must derive from a trade or business, be regularly carried on, and be unrelated to the organization’s exempt purpose. For instance, income from a church-operated coffee shop open to the public may be considered unrelated business income if it does not serve the church’s religious mission. Such income is taxed at corporate rates, and organizations must file Form 990-T if unrelated business income exceeds $1,000.

Certain activities, such as volunteer-operated businesses or sales of donated goods, are excluded from UBIT. Passive income streams like dividends, interest, and royalties are generally exempt unless tied to debt-financed property. Understanding these distinctions is crucial for organizations seeking to diversify income without jeopardizing tax-exempt status.

Charitable Contributions and Deductions

Charitable contributions are a key funding source for churches and religious organizations. Under IRC Section 170, individuals and corporations can deduct contributions made to qualified organizations, provided no substantial benefit is received in return.

Donors must ensure their contributions go to IRS-recognized tax-exempt entities under Section 501(c)(3). Proper documentation, such as receipts or bank statements, is required to substantiate deductions. For contributions over $250, a written acknowledgment from the organization is mandatory.

The Tax Cuts and Jobs Act (TCJA) of 2017 increased the standard deduction, reducing the number of taxpayers itemizing deductions and potentially impacting charitable giving. Temporary provisions under the CARES Act allowed higher deduction limits for cash contributions in certain years, creating opportunities for donors to maximize tax benefits.

Employee Compensation and Benefits

Managing employee compensation and benefits requires balancing tax obligations with staff well-being. Salaries must reflect fair market value to comply with the IRS’s “reasonable compensation” standard. Non-monetary benefits, such as housing allowances or tuition discounts, must also meet this standard.

Payroll tax compliance is critical. Clergy are considered self-employed for Social Security purposes but require income tax withholding, reported on Form W-2. Non-clergy employees are subject to standard withholding requirements, which organizations must remit promptly to avoid penalties.

Employee benefit plans, including health insurance and retirement options, must comply with regulations like the Employee Retirement Income Security Act (ERISA) and the Affordable Care Act (ACA). Offering a 403(b) retirement plan is a strategic choice, providing tax advantages for employees and organizations alike.

Housing Allowance for Clergy

The housing allowance, or parsonage allowance, is a significant tax benefit for clergy. It allows clergy to exclude from federal income tax the portion of their income used for housing expenses, including rent, mortgage payments, utilities, and furnishings. Churches must designate the allowance in advance and ensure it is reasonable based on actual housing costs.

The exclusion is limited to the lesser of the designated allowance, actual housing expenses, or the fair rental value of the home. While exempt from federal income tax, the allowance remains subject to self-employment tax. Clergy should carefully document housing expenses to substantiate the exclusion if audited. Churches must provide clear guidance to ensure compliance and maximize this benefit.

Recordkeeping and Reporting

Effective recordkeeping and reporting are essential for transparency and compliance. Churches and religious organizations must maintain detailed records of income, expenses, and charitable contributions. Proper documentation ensures accuracy in financial reporting and readiness for audits.

Financial statements, such as balance sheets and income statements, should follow Generally Accepted Accounting Principles (GAAP) to provide a clear financial picture. Regular internal audits or reviews can help identify discrepancies and improve practices. For organizations required to file IRS Form 990, accurate and timely reporting is critical for maintaining tax-exempt status and demonstrating accountability.