Pauline had kept the books and done payroll for her husband’s business for years, long enough to be fully familiar and confident with it. With their kids out of the house and more time on her hands, Pauline had been glad to accept her church’s offer of its part-time bookkeeping position. In her orientation from the church’s departing bookkeeper, Pauline quickly discovered that the church’s bookkeeping hardly varied from her husband’s for-profit business, except for the corporate income taxes and local property taxes. Pauline took a little while to get used to the differences, but overall, the church bookkeeping was only slightly less complicated. One thing was sure: the church still had taxes to pay.
Policy
The American people and their nation and states have long respected the independence and ministries of churches. The Constitution’s First Amendment further assures that the government must not interfere with the free exercise of religion. Congress has carried that assurance and respect forward into federal laws relieving churches of income tax obligations borne by other organizations. States have done likewise through their constitutions and state laws, while also often relieving churches of property and sales tax obligations. Other ordinary tax obligations remain, such as to pay employment taxes when compensating church staff and taxes on utilities, fuel, and other goods and services in the same manner that businesses and individuals pay those taxes. Churches thus face a complex tax landscape that their administrators must navigate with care, to take lawful advantage of tax relief while paying all due taxes. Ensure that your church knows the tax landscape.
Grounds
Understanding why governments relieve churches of some taxes can help you ensure what taxes to pay and not to pay. The point of tax relief is twofold. First, the government must not interfere with or unduly burden the free exercise of religion. Taxes can interfere and burden. Taxpayers generally do less of whatever the government taxes. Thus, fundamentally, the government should not tax a church on its income from member and guest donations because the tax would reduce donations, burdening and interfering with the free exercise of religion. The second reason the government has for relieving churches from certain tax obligations is that churches provide charitable service of the sort that the government might have to otherwise provide. Tax a church that operates soup kitchens, homeless shelters, job training, transportation services, counseling services, and other ministries for the disadvantaged, and you’ll get less of those services, removing a safety net that the government may then have to provide. Keep those grounds for relief in mind when seeking due relief for your church under the tax laws.
Exemption
The way in which the IRS and state and local tax authorities relieve churches from paying certain taxes is through exemption provisions. Internal Revenue Code Section 501(c)(3) is the primary exemption provision. Section 501(c)(3) relieves churches and other charitable and religious organizations from federal income taxes when “organized and operated exclusively for religious, charitable, scientific, testing for public safety, literary, or educational purposes,” while satisfying other conditions. Qualifying your church as tax exempt under Section 501(c)(3) also enables donors to your church to qualify for charitable deductions from their own income taxes. If the IRS recognizes your church as exempt from federal income tax, your state is also likely to exempt your church from state income tax. Most states do so. Your church may also be exempt from local city income taxes, again dependent on the city. Qualifying for tax exemption under Section 501(c)(3) may also assist your church in qualifying for exemption from local property taxes and from paying state sales taxes on purchases, depending on state and local laws. You can see the several advantages from gaining Section 501(c)(3) tax exemption.
Determination
The IRS maintains an online procedure for your church to gain a determination letter from the IRS confirming your church’s tax-exempt status. While technically, your church may be exempt from federal income tax even if it does not get an IRS determination letter, prudence more likely dictates that your church obtain such a letter, not only to ensure that your church complies with federal and other tax laws but also to reassure donors, especially those who intend to qualify for their own charitable contribution tax deductions. Completing the IRS’s online procedure for a Section 501(c)(3) determination letter can be relatively complex. See the guide Help with Your 501(c)(3) for a description of the full process of qualifying for tax-exempt status.
Income
Understand the federal income tax from which Section 501(c)(3) exempts qualifying churches and other charitable and religious organizations. Churches receive member and guest donations. They may also generate modest revenue from fees they may charge for courses, conferences, activities, and events, church publications and merchandise, and other mission-related goods and services. Expenses may equal or exceed revenue. But if not, and the church has excess revenue over expenses, Section 501(c)(3) relieves the church from paying taxes on that net revenue. If the church had no exemption, the IRS would treat the church as it would any other business, classify the net revenue as profit, and assess the federal income tax on that profit. Churches generally need not worry about paying federal income tax on excess revenue after expenses for their religious and charitable activities. Indeed, churches often accumulate excess revenue year after year, to fund capital expenditures like new or renovated facilities, or pursue new ministries.
Unrelated
Churches must be cautious, though, not to conduct commercial activities in competition with businesses, unrelated to the church’s religious and charitable mission. Section 501(c)(3) only relieves a church from federal income tax on net revenue generated from mission-related activities. If instead a church profitably leases its parking lot during the week to businesses or takes on some other profitable commercial activity unrelated to its religious and charitable purpose, the church must report that profit to the IRS as unrelated business income and pay the unrelated business income tax (UBIT). Keep your church from conducting business activities, or prepare to account for the profit and to pay the tax.
Sales
Churches regularly buy goods on which the retail seller must ordinarily charge sales tax. For example, the church maintenance director may buy tools or supplies at the hardware store. The church custodian may order cleaning supplies online. The worship director may purchase a musical instrument for the church band. Ordinarily, buyers would pay state sales tax and may also pay a local sales tax on these types of transactions. But many states and locales exempt churches from paying sales taxes either on any item or certain types of items. States exempting churches from sales taxes generally require the church to obtain a certificate or card and number confirming the exemption. Staff members can then present that documentation to the seller when buying church goods, to qualify for the exemption. Importantly, churches are not generally exempt from collecting sales tax on goods they sell, whether church publications or church merchandise, to remit to the state or locale. And if a church sells goods unrelated to its religious mission, such as manufactured trinkets having no religious purpose, the church may have to pay unrelated business tax on any profit.
Property
Churches owning real property generally qualify for exemption from real property tax obligations, provided that they use the property for religious purposes that the state or locale recognizes as exempt. Those purposes generally include worship services, religious education, and other ministry-related uses. But states and locales vary in the nature and extent of their real property tax exemptions for churches. And churches must generally apply and qualify for the exemption as soon as acquiring the property or may owe a tax obligation arising before the tax authority grants the exemption. Don’t ignore real property taxes. Instead, promptly seek exemption, and get qualified attorney representation over any tax dispute.
Employment
Churches are not generally exempt from employment taxes relating to their paid staff members. Both for-profit and nonprofit employers, including churches and other 501(c)(3) charitable and religious organizations, must generally withhold federal and state income taxes that their employees owe, and remit those withheld taxes to federal and state tax authorities. Churches, like other employers, must also pay the employer’s matching portions of Medicare and Social Security taxes, known as FICA taxes. On the other hand, churches are generally exempt from the federal unemployment tax, known as FUTA. Some states exempt churches from the state unemployment tax, known as SUTA, while other states require churches to pay the state tax. In short, churches generally only have limited employment-tax relief, from only the federal unemployment tax. Those who control and manage the church’s finances may have personal liability for an IRS trust fund recovery penalty (TFRP) relating to unpaid employment taxes. Ensure that your church manages its tax obligations lawfully.
Reflection
Does your church have a 501(c)(3) determination letter to confirm its tax-exempt status for donors and others? Does your church retain net revenue over expenses, to build a cash reserve or fund capital improvements? If so, have you confirmed your church’s exemption not just from federal income taxes but also from state income taxes? Does your church conduct any unrelated business activity from which it earns profits, on which it should be paying taxes? Does your church own real property? If so, does your church use the property that it owns only for religious purposes? And has your church sought exemption from real estate taxes on that property? Is your church paying all due employment taxes, including the employer’s portion of FICA taxes?
Key Points
Churches have historically found federal and state tax relief.
Grounds include religious freedom and a church’s charitable works.
Churches qualify for tax relief through statutory exemptions.
The IRS offers qualifying churches a tax-exempt determination letter.
The primary tax relief is from federal income tax on net revenue.
Churches must still pay income tax on unrelated business income.
Some states relieve churches from paying state sales tax.
Some states and locales relieve churches from paying property taxes.
Churches pay employment taxes except for federal unemployment.