Is My Church Being Overseen by Wise Counsel or Wise Guys?
Starting and running a church can be a more complex task than it appears at first blush. There are the usual requirements for starting a church: finding a good pastor, finding a place of worship, and building a strong member community. Even with these elements, however, a church can run aground of basic legal requirements, both at the state and federal levels. Building a church should mirror the growth of Jesus as a young child, when he “increased in wisdom and in stature and in favor with God and man.” Luke 2:52 (ESV) (emphasis added). Although it is in our human nature to shoulder these responsibilities upon ourselves, this article will address why it is essential to seek counsel to avoid the dangers and pitfalls of running a successful church, not only in the eyes of the members but of the government and law.
I. Church defined and automatic § 501c3 tax exempt status
The Internal Revenue Service (hereinafter the “IRS”) grants churches, along with church conventions, church associations, and integrated auxiliaries, tax exempt status under Internal Revenue Code (“IRC” or the “Code”) § 501c3 without requiring these organizations to submit a formal application for recognition as a 501c3 entity. IRS Publication 1828 – Tax Guide for Churches and Religious Organizations (Rev. Nov. 2013).
Like all charitable organizations, the church must meet the following characteristics:
1) it must be organized and operated exclusively for religious, charitable, educational, or other tax exempt purposes;
2) its net earnings cannot inure to the benefit of a private individual(s);
3) a substantial part of its activities cannot be for influencing legislation;
4) none of its assets can be used to intervene in political campaigns; and
5) the church’s purpose and activities must not be illegal or violate public policy.
Although churches are not required to file a Form 1023, asking the IRS to grant them tax exemption, a church must meet the basic definition of a “church” to ensure they qualify for “automatic” tax exemption. If a church fails to meet these requirements, it runs the risk of being categorized simply as a charitable, religious organization and would be required to seek formal determination of its §501c3 tax exempt status. Although the IRS has not specifically defined a “church,” various IRS and court determinations have listed characteristics typically observed and engaged in by a “church.” This factor-based test looks at some of the following characteristics:
- Distinct legal existence;
- Recognized creed and form of worship;
- Definite and distinct ecclesiastical government;
- Formal code of doctrine and discipline;
- Distinct religious history;
- Membership not associated with any other church or denomination;
- Organization of ordained ministers;
- Ordained ministers selected after completing prescribed courses of study;
- Its own literature;
- Established places of worship;
- Regular congregations and religious services; and
- Sunday schools for the religious instruction of the young.
There is no prescriptive rule that makes any of these characteristics more important than any others, so each circumstance must be judged individually. Churches are granted multiple benefits by the IRS, including some that are specific to churches only. One of these specific benefits is that a church is not required to annually file a Form 990 (Return of Organization Exempt from Income Tax) with the IRS.
II. Duties and Responsibilities of Leadership in a § 501c3 organization
Although a church is not required to seek a formal tax exempt determination or file an annual Form 990, a church needs to be aware that it will be held to the same standards of all § 501c3 tax exempt entities, regardless of whether it is incorporated under state law or operating as an unincorporated church association under state law. Whether or not a church has incorporated, it must comply with IRS rules and regulations to ensure it keeps its tax-exempt status.
In nonprofit and church corporations, the leadership is typically comprised of a Board of Directors and Officers who are identified in the Bylaws. These Directors and Officers are responsible for overseeing the general operations of the entity, making policy decisions, and carrying out the specific duties outlined under state law, under the Bylaws and policies of the corporation, or through any Board resolution. For unincorporated church associations, the leadership is comprised of individuals identified in the church governing documents who are responsible for these same duties and responsibilities (i.e. Elders, Deacons, Leadership Team, Counsel, etc.). Because the duties and responsibilities are the same for both incorporated and unincorporated churches, church leadership will hereinafter be referred to as “Directors,” “Officers,” or collectively the “Board.”
A. Number and Composition
The IRS requires entities seeking tax exempt status to identify any and all business and family relationships among their Board members. The IRS also requires these entities to list the total compensation paid to the Board members by the entity. By requiring these disclosures, the IRS is seeking to limit the possibility of a conflict of interest and ensure that those in leadership are making decisions in the best interest of the entity.
Although the minimum number of Directors for a nonprofit corporation vary by state (e.g. Virginia only requires one director of a non-stock corporation), the IRS has historically denied granting § 501c3 tax exempt status to an organization which has less than three (3) Board members. This denial is due to the appearance that the organization is operated primarily for the private benefit of the Director(s) as opposed to a public benefit.
Thus, a church Board should consist of at least three (3) members with the majority of those members being individuals who are neither paid church staff, directly related to paid church staff, or related to each other through blood or marriage. A majority of the Board members not being directly or indirectly compensated by the entity or having familial ties reduces the likelihood of Board decisions being influenced by outside personal factors. A plurality of Board members allows for various viewpoints to be discussed and for the members to reach an objectively informed decision before a vote. The use of an odd number also reduces the likelihood of a stalemate when voting. There is no statutory limit on the maximum number of Board members as all tax exempt organizations vary in size and complexity.
In determining an appropriate number of Board members, two questions the Board should ask are 1) “Are the Board members fulfilling their fiduciary duties?” (discussed more fully below) and 2) “Are the Board members providing value in their time and talents to the church?” If the answer is “No” to either of these questions, then the Board may want to consider increasing or decreasing the total number of Board members, provided that a decrease should not be below three (3) total members.
B. Fiduciary Duties
The Directors and Officers of for-profit companies are expected to uphold certain fiduciary duties on behalf of the company upon accepting those positions. In recent years, the courts have extended these fiduciary duties onto the Board members of non-profit organizations as well.
One of the two primary duties is a fiduciary duty of care. Under the duty of care, Board members are expected to carry out the aforementioned duties in a manner that can reasonably be said were in the best interests of the corporation. The decision-making process, similarly, must exhibit reasonable care and prudence. In carrying out their duties, Board members are expected to, among other duties, regularly attend Board meetings, review and become familiar with issues being presented to the Board for discussion and voting, reviewing the church’s financial status and reasonably investigating inconsistencies.
The second related duty is that of the fiduciary duty of loyalty. This duty is akin to the warning that Jesus provides to his Disciples in Matthew 6:24: No one can serve two masters. Either you will hate the one and love the other, or you will be devoted to the one and despise the other. (NIV) Under the duty of loyalty, a Director may not use his or her position on the Board to obtain an unfair personal benefit.
The typical scenario where the duty of loyalty arises is when the church enters into a contract for a third party to provide some services (i.e. construction, custodial, IT support, etc.) to the church. Under the duty of loyalty, if a Director would obtain a personal benefit by the church entering into this agreement, that Director must disclose his or dual interest in the transaction before the church Board enters into it. A second, less typical, scenario is one where a Director usurps a corporate opportunity. This means that an individual Director may not use the information he or she gains while serving on the church Board for a personal benefit he or she would not otherwise deserve.
The IRS’ basis for the minimal number and composition of the Directors and the fiduciary duties of Board is to assure that those in leadership are being held accountable to one another and that they are being good stewards of the resources being provided. Scripturally, church leaders are also expected to be held accountable and to be good stewards of the church’s resources. See Hebrews 3:12-13; 10:25; Proverbs 24:24-25; and James 5:19-20 on being held accountable to one another. See Luke 12:42-46, 1 John 2:15-17, Titus 1:7-9; 2:7 on good stewardship.
III. Liability of Directors and Officers of a § 501c3 organization
One of the benefits of a corporate structure is that Directors and Officers are generally immune from personal liability for Board actions and decisions connected to the operations of the nonprofit organization. Directors are also typically not liable for the Board’s actions prior to their election or after their resignation. However, a Director’s liability will continue for any action taken prior to his or her resignation or removal. This section outlines the typical areas where personal liability of Board members may come into effect. As with the duties and responsibilities discussed above, because these rules are IRS requirements, they apply regardless of the church’s incorporated status with the state.
A. Tort Liability
Directors and Officers are generally immune from liability from church torts unless they personally commit, direct, or participate in the tort itself. For example, a lay Director would not likely be personally liable for a claim of negligence against the church for injuries if the church van ran a stop light and was struck by another vehicle in the intersection. However, if that Director was the individual driving the church van and did not stop at the light because he or she was texting on her cell phone, that Director would be personally negligent and be liable to the other passengers.
Another more extreme example where a Director may be personally liable would involve the negligent hiring of an employee. Because a youth pastor or staff member abuses a child, the parents bring a lawsuit against the church or agree to arbitration. During discovery, it is unearthed the youth pastor had been previously convicted of aggravated assault of a minor. When asked, the Board members who were part of the call committee admit they did not perform a criminal background check on the youth pastor. As a result of this admission, the parents could amend their complaint to include the two Board members personally along with the church for damages.
B. Contract Liability
Generally, Board members are not personally liable when signing a contract on behalf of their church unless one of two situations occurs: 1) the Board member was not authorized to sign the contract or 2) he or she signed the contact without a clear indication they were signing only in a representative capacity.
In order to avoid or reduce personal liability, those Board members who are not already authorized to sign contracts under the church’s governing documents should request a written Board resolution granting such authorization prior to executing the contract. Additionally, the Board member should always review the contract to confirm or include the church’s name and his or her title on the signature line.
C. Breach of the Fiduciary Duties of Care and Loyalty
Board members fulfill their duty of care by taking reasonable actions which are objectively in the best interest of the church. As discussed above, reasonable action includes regular attendance at regularly scheduled meetings, active participation in Board discussions, and voting for or against matters brought for a vote.
For churches, particularly unincorporated associations, this duty of care and the potential personal liability for breaching it should be on the forefront for those in leadership positions. Board members may rely on information, statements, reports, and opinions by those individuals reasonably believed to be reliable and competent as a basis for their decisions. However, Board members cannot simply act as a sounding board for one or two Board members and must engage in some level of independent judgment of the information presented in reaching that decision.
Pertaining to the duty of loyalty, when a Director knows that he or she has a potential conflict of interest, it is that Director’s duty to fully disclose that conflict of interest to the Board. Once disclosed, the Board may still decide to enter into the agreement so long as 1) the agreement was fair and reasonable to the corporation; 2) the agreement was approved by the appropriate vote of the remaining Board members; and 3) the remaining Board members determined in good faith that a more advantageous arrangement could not be obtained under the circumstances.
For one very clear example of a Board of Directors who breached their fiduciary duties of care and loyalty to their nonprofit ministry, one only needs to look to the PTL ministry and Rev. Jim Bakker. As a result of claims and counter-claims for damages brought before it, the Bankruptcy Court reviewed the actions of Rev. Bakker and David Taggart, his Vice President, in their executive positions within the ministry. The Court found that both individuals had egregiously violated their duty of care and loyalty to PTL, including, but not limited to:
- A systematic failure to inform the Board of the ministry’s actual financial situation so they could properly act;
- Violation of the prohibition on self-dealing;
- Failed to prevent the depletion of ministry assets; and
- Failed to supervise other Board members.
Additionally, the Court reviewed the general procedures and decision-making, or lack thereof, of the PTL Board members. The Court found that the PTL Board as a whole failed in upholding their fiduciary duties to the ministry in the following ways:
- The Board members never requested nor were never shown the financial statement of the ministry.
- The Board members were never presented with any information or correspondence by the ministry’s VP of Finance.
- Board members approved bonuses without knowledge of the actual amounts granted and such amounts were only attached after the fact.
- Board members solely relied on the statements of Rev. Bakker as to the financial status of the ministry.
- Rev. Bakker selected and had great influence over all members of the Board to the extent that Board members rarely disagreed or refused his requests.
As evidenced in Heritage Village, the action of one or more individual Board member violating these fiduciary duties is punishable. However, the inaction of the Board as a whole in correcting or stopping that individual Board member is also punishable.
Where there is no guidance, a people falls, but in an abundance of counselors there is safety. Proverbs 11:14. Leadership of a church or religious nonprofit need to be comprised of individuals who not only have a heart for seeing the entity succeed but also have a clear head in making decisions which are in the best interests of that entity. An individual agreeing to serve in a leadership role, whether paid or unpaid, also agrees to certain legal and scriptural duties and responsibilities on behalf of the church. Individuals should understand and prayerfully consider both their individual and collective responsibilities before agreeing to serve in a church leadership capacity.
Disclaimer: This memorandum is provided for general information purposes only and is not a substitute for legal advice particular to your situation. No recipients of this memo should act or refrain from acting solely on the basis of this memorandum without seeking professional legal counsel. Simms Showers LLP expressly disclaims all liability relating to actions taken or not taken based solely on the content of this memorandum. Please contact Robert Showers at firstname.lastname@example.org or Justin Coleman at email@example.com for specific legal advice on this issue for your needs. Simms Showers LLP © 2014
http://www.irs.gov/Charities-&-Non-Profits/Churches-&-Religious-Organizations/Churches–Defined. PLR 200736037 (IRS denying § 501c3 tax exempt status to an entity due in part to a father and son serving as the sole Directors and Officers of the entity). In re: Heritage Village Church and Missionary Fellowship, Inc., 92 B.R. 1000 (D.S.C. 1988). Id. at 107-108.