Memorandum. Rev. Stephen C. Kanouse Director for NTNL Evangelical Missions. Church Property Use and Taxation. Date: August 17, 2013

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1 Memorandum To: From: Subject: Rev. Stephen C. Kanouse Director for NTNL Evangelical Missions Nolan Clemens Principal, Sedona Group, Inc. and Member, Abiding Grace Lutheran Church Church Property Use and Taxation Date: August 17, 2013 Like all newly formed nonprofit organizations, our church members and management continue to be challenged by the need to better understand today s changing regulations and community expectations. Your guidance has been invaluable in our development of the knowledge, policies and procedures required to meet these challenges. Thank you! Following is a summary of selected property use and income tax information I recently developed for our Church Council and Finance Committee. This summary addresses the efforts of various taxing authorities to identify and penalize business entities that falsely present themselves as nonprofit church operations and/or fail to conform to the expanded accounting and reporting requirements for non-typical revenue producing activities. Most of the following was developed from a more detailed IRS publication, Tax Guide for Churches and Religious Organizations. A copy of this publication is available at the Website listed in Exhibit 1. Exhibit 2 introduces the reader to the significant tax related resource materials available from the Office of the Secretary of the Evangelical Lutheran Church in America. A third exhibit includes a copy of IRS Form 990-T, the tax return that a churches are required to complete if they have substantial income (generally $1,000 or more) from unrelated activities. Exhibit 4 includes a dramatic example of the global change faced by churches in property use and taxation. I understand that you may place this document on the NTNL Website. To ensure we don t upset the IRS or various other entities, I ask that the reader be aware of the following disclaimer: Please be informed that any U.S. federal tax advice contained in this communication (including any attachments) is not intended or written to be used, and cannot be used, for the purpose of (i) avoiding penalties under the Internal Revenue Code or (ii) promoting, marketing, or recommending to another party any transaction or matter addressed herein. The following information is not intended to be legal, accounting, tax, payroll, investment or other professional advice. Before making any decision or taking any action that might affect your personal finances or business, you should consult a qualified professional advisor who understands your particular factual situation. Sedona Group, Inc Page 1

2 The Church as a Tax-Exempt Entity U.S. churches have been unofficially tax-exempt since the country's founding and received an official federal income tax exemption in This exemption can be found in Section 501 of the Internal Revenue Code (IRC section 501(c) (3)). Currently, all 50 US states and the District of Columbia generally exempt churches from paying property tax and consider donations to churches as tax-deductible. It should be noted that there is a growing debate over whether these tax benefits should be continued. While proponents suggest that tax-exemption supports the separation of church and state, opponents argue that the decline in the global economy and the growing abuse of the tax-exempt designation suggests a need for increased regulatory reporting and control. Proponents argue that a tax exemption for churches keeps the government out of church finances and thus upholds the separation of church and state. These advocates further maintain that churches deserve a tax break because they can more effectively identify and provide social services to persons in need. Finally, church organizations usually point to the fact that 200 years of tax exemptions have not turned America into a church controlled entity. Opponents of the current tax exemption standards offer the following arguments: Giving churches special tax treatment violates the separation of church and state. Tax exemption is a privilege, not a constitutional right. As much as one-quarter to one-half of a typical U.S. city may be made up of tax-exempt property, including churches or church schools. These extensive property tax exclusions equate to a subsidy of billions of dollars every year. Current IRS regulations unfairly favor churches by automatically granting tax exemption as opposed to requiring them to file a request for an exemption like other non-profits. This exception from the process followed by other non-profits has resulted in the creation of tax-exempt organizations without adequate structure or management. The IRS should discontinue the current practice that exempts houses of worship from filing a Form 990 as required of other tax-exempt charities. This has permitted tax avoidance by firms who have illegally conducted for-profit business activities within taxexempt organizations. Generally, most organizations exempt from income tax must file an annual information return (Form 990 or Form 990-EZ). Tax-exempt organizations that have annual gross receipts less than $25,000 ($50,000 for tax years ending on or after December 31, 2010) are not required to file the annual information return. However, they may be required to file an annual electronic notice. Most small tax-exempt organizations whose annual gross receipts are normally $50,000 or less are required to electronically submit Form 990-N, also known as the e-postcard, unless they choose to file a complete Form 990 or Form 990-EZ. In addition, churches and certain churchaffiliated organizations are exempt from filing if the entity conforms to one or more of the following definitions: Sedona Group, Inc Page 2

3 o A church, an interchurch organization of local units of a church, a convention or association of churches. o An integrated auxiliary of a church. o A church-affiliated organization that is exclusively engaged in managing funds or maintaining retirement programs. o A school below college level affiliated with a church or operated by a religious order. o Church-affiliated mission societies if more than half of their activities are conducted in, or are directed at, persons in foreign countries. o An exclusively religious activity of any religious order. The Unrelated Business Income Tax (UBIT) For an organization to qualify as a church under the IRS Code, its activities must be directed exclusively toward charitable, educational, religious, or other exempt purposes. Such activities may not serve the private interests of any individual or organization. More specifically, the income in question may not be subject to tax if it meets one of the following exceptions: substantially all of the work in operating the trade or business is performed by volunteers; the activity is conducted by the organization primarily for the convenience of its members; or the trade or business involves the selling of merchandise substantially all of which was donated. Churches may engage in income-producing activities unrelated to their tax-exempt purposes as long as they are not a substantial part of the organization s activities. If the amount is substantial, it will be subject to the Unrelated Business Income Tax (UBIT). While the current Federal tax regulations do not clearly define the amount that is to be considered substantial, recently reported IRS actions suggest a church may be expected to report all forms of unrelated business income that individually exceed $1,000 in any taxable year. Reporting by the church is accomplished by filing Form 990-T, Exempt is Organization Business Income Tax Return, for the year in question. A copy of Form 990-T is included in Exhibit 3. The IRS can be expected to conduct a review of Form 990-T to determine if the unrelated business activities may be subject to the UBIT. Specifically, the IRS can be expected to conduct a combination of telephone interviews and/or onsite review of church records to determine if the following three conditions are met: the activity constitutes a trade or business, the trade or business is regularly carried on, and the trade or business is not substantially related to the organization s exempt purpose. Sedona Group, Inc Page 3

4 The fact that the organization uses the income to further its charitable or religious purposes does not make the activity substantially related to its exempt purposes. Rents from real property, royalties, capital gains, and interest and dividends are not subject to the unrelated business income tax unless financed with borrowed money. Generally, income derived from the rental of real property and incidental personal property is excluded from unrelated business income. However, the IRS has been successful in a number of tax cases situations in which rental income has been defined as unrelated business taxable income including the following: If a church rents out property on which there is outstanding debt, such as a mortgage note. However, there are examples of recent tax decisions involving churches, conventions or associations of churches that acquired debt-financed land for exempt purpose use within 15 years of the time of acquisition and the income from the rental of the land was determined to not constitute unrelated business income. If personal services are rendered in connection with the rental, then the income may be unrelated business taxable income. If a church charges for the use of the parking lot, the income may be unrelated business taxable income. Current Taxing Authority Efforts Various publications have reported a significant increase in reviews by the IRS and other taxing authorities regarding unrelated trade or business activities income earned by tax exempt entities. These reviews have produced varying results including: No reported change, or The loss of all or part of the tax exempt status by the nonprofit with an accompanying payment of taxes, penalties and interest, and/or A requirement that the donor will not be allowed to consider his contribution as a tax exempt gift. A number of publications have also reported an increase in the number of adverse actions by taxing authorities in other countries. As an example consider the following: Church education programs and the church property was reclassified as a for profit operation subject to related taxation. (Reference Exhibit 4: Catholic Church to Lose Historic Property Tax Exemption in Italy) Various religious organizations lost the tax exempt status on book stores, service providers and manufacturing firms when it was determined their operations produced significant revenues that were outside the designated tax-exempt purposes. Sedona Group, Inc Page 4

5 Summary I believe the information presented above affirms the need for documented property protection and management standards. For example, while it may be very tempting to rent church office space to a third party at current market rates, recent efforts by the IRS and other government authorities suggest that we need to proceed very carefully with such an arrangement. I hope this information will be helpful in our planned discussions and further analysis. Please contact me at nclemens@sedonainc.com if you have any questions or concerns. Sedona Group, Inc Page 5

6 Exhibit 1 Internal Revenue Service, Department of the Treasury, ( Tax Guide for Churches and Religious Organizations, Publication 1828, Catalog Number 21096G, 01 November Sedona Group, Inc Page 6

7 Exhibit 2 Evangelical Lutheran Church in America, Office of the Secretary, ( Questions About Tax Status, (30 May 2013) Summary: This ELCA publication examines the Internal Revenue Service (IRS) procedure by which a parent organization (in this case the Evangelical Lutheran Church in America) can establish a federal income tax exempt status for its subordinate organizations. The material also reviews the various state rules relating to exemptions from sales and real estate taxes as well as the process required to secure tax exemptions. Topics include: Local real estate tax issues Taxation of a Congregation's Rental Income Political activity and tax status Endorsing a commercial third party product Tax information for donors Tax information for the clergy Independent Contractor vs. Employee Evangelical Lutheran Church in America, Office of the Secretary, ( Taxation of a Congregation s Rental Income, (30 May 2013) Summary: Since 1969, churches have been subject to the Unrelated Business Income Tax (UBIT) for federal income tax purposes, to the same extent as other 501(c) (3) taxexempt organizations. A church that is liable for UBIT must file an IRS Form 990-T by the 15th day of the 5th month following the end of its fiscal year. Evangelical Lutheran Church in America, Office of the Secretary, ( Exceptions to file Form 990, 990-EZ and 990-N, (30 May 2013) Summary: The following is a list of some of the organizations that are not required to file Form 990, 990EZ or 990-N: Churches (as opposed to religious organizations, Inter-church organizations of local units of a church, Mission societies sponsored by or affiliated with one or more churches or church denomination, if more than half of the activities are conducted in, or directed at, persons in foreign countries, and An exclusively religious activity of any religious order. Sedona Group, Inc Page 7

8 Exhibit 3 Internal Revenue Service, Department of the Treasury, Form 990-T Exempt Organization Business Income Tax Return, 01 November It should be noted that the IRS instructions for the preparation of this form include an estimate of the time needed to complete and file this form. They acknowledge that the required time will vary with individual circumstances. However, they suggest the following estimated average time requirements: Recordkeeping 67 hours Learning about the law or the form 27 hours Preparing the form 43 hours Copying, assembling and sending the form to the IRS 4 hours Sedona Group, Inc Page 8

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13 Exhibit 4: Catholic Church to Lose Historic Property Tax Exemption in Italy time: October 13, :38 Italy s Catholic Church will be forced to pay taxes starting in 2013 after the EU pressured the country s government to pass a controversial law stripping the Church of its historic property tax exemption. The Catholic Church in Italy is excluded from paying taxes on its land if at least a part of a Church property is used non-commercially for instance, a chapel in a bed-and-breakfast. "The regulatory framework will be definite by January 1, 2013 the start of the fiscal year and will fully respect the [European] Community law," Italian premier Mario Monti's government said in a statement on Tuesday. The move could net Italy revenues of 500 million to 2 billion euros annually across the country, municipal government associations said. The extra income from previously exempt properties in Rome alone including hotels, restaurants and sports centers could reach 25.5 million euros a year, La Repubblica daily newspaper reported. On Monday, the Council of State, Italy's highest ranking court for administrative litigation, ruled against the new law. Authorities stepped in, arguing that everyone in Italy should pay property tax, including the Church. The measure came after the country s leadership decided in February to alter Italy s property tax code, ending the Church s longstanding privileges due to the severe debt crisis. Last December, after new austerity measures were adopted in the country, 130,000 Italians signed an online petition urging the government to strip the Church of its tax exemption. It was time that they paid, too, with all the exemptions they ve had throughout the years, Marco Catalano, a 35-year-old shopkeeper in Rome, told the New York Times in February, adding that he goes to church twice a month. They own the most beautiful buildings in downtown Rome, on Italian soil, and rent them out at market prices. They don t give them for free or at low prices for charity. Two years ago, the EU began to investigate whether the tax privileges of some Church properties in Italy could be considered illegal state aid. Sedona Group, Inc Page 13

Unrelated Business Income Overview

Unrelated Business Income Overview Trainer: Michael J. Peterson, CPA, Manager 1 Materials/Disclaimer Please note that these materials are incomplete without the accompanying oral comments by the trainer(s).