Church Finances and Business: Should My Church Incorporate? (Federal law)

Tax exempt status

Another reason to incorporate is to obtain 501(c)(3) status. Now, this is a body of law that many misunderstand, and so I’m going to start with basics.

1. All income is subject to the federal income tax unless there’s a statute creating an exception. This is true whether the income is earned by a corporation, a trust, a church … whatever. The US Congress taxes all income, and the US Constitution specifically approves this. But, of course, there are exceptions.

The only exception likely to apply to a church is Internal Revenue Code (IRC) section 501, which lists many different kinds of organizations that are exempt from the income tax. If you aren’t listed in section 501 (or in another exemption), your income is taxable.

501(c)(3) is the subsection that churches want to come under, because 501(c)(3) does two good things — it exempts the church from the income tax and IRC section 170 makes contributions to a 501(c)(3) organization tax deductible.

(3) Corporations, and any community chest, fund, or foundation, organized and operated exclusively for religious, charitable, scientific, testing for public safety, literary, or educational purposes, or to foster national or international amateur sports competition (but only if no part of its activities involve the provision of athletic facilities or equipment), or for the prevention of cruelty to children or animals, no part of the net earnings of which inures to the benefit of any private shareholder or individual, no substantial part of the activities of which is carrying on propaganda, or otherwise attempting, to influence legislation (except as otherwise provided in subsection (h)), and which does not participate in, or intervene in (including the publishing or distributing of statements), any political campaign on behalf of (or in opposition to) any candidate for public office.

As you can see, the word “church” does not appear in the statute, but churches have been recognized as “religious” and “charitable” for centuries. And the IRS recognizes that churches are, as a rule, 501(c)(3) organizations.

To be a 501(c)(3) organization, the regulations require that certain language be in the documents. Of course, if there are no organizational documents, none of the required language will be there, and the organization will not qualify.

Fortunately, there’s an exception for organizations founded before 1959, but newer churches don’t qualify under the regulations unless their organizational documents have the right words.

2. Some want to argue that the First Amendment creates an exception for churches, but it doesn’t. However, it does cause the IRS to be very deferential to churches and to very rarely audit them. Nonetheless, the rules are the rules.

3. The law requires organizations to obtain a favorable, written ruling from the IRS before they can be treated as qualifying under 501(c)(3) — except for churches. Churches aren’t required to obtain a ruling. If they don’t have a ruling, they aren’t automatically taxable — they just don’t have a ruling, meaning their tax exempt status depends on whether they meet the rules. If they have a ruling, they’ve proven that they meet the rules. If not, they might still meet the rule, but it won’t be proven.

Therefore, it’s not essential for a church to obtain a 501(c)(3) ruling, but it’s prudent to do so. Moreover, some grants and other benefits may require a ruling. And some donors may be reluctant to make a gift without a ruling.

But getting a ruling doesn’t change the rules for what makes you exempt or not. It just changes how certain you can be that you qualify and how easily you can prove your qualification to donors and other governmental agencies.

Propaganda

Perhaps the most controversial aspect of 501(c)(3) status is the rule that “no substantial part of the activities of [the church] is carrying on propaganda, or otherwise attempting, to influence legislation … , and [the church may] not participate in, or intervene in (including the publishing or distributing of statements), any political campaign on behalf of (or in opposition to) any candidate for public office.”

This is often seen as a rule motivated by a desire to silence churches, but it applies to all charities of any kind that seek tax exempt status — and it’s original motivation was revenue-driven. The idea is that donations to political candidates and to efforts to pass laws should not be deductible. Therefore, if charities could engage in these activities, then it would be easy to contribute to the charity, take a deduction, and have the church give the money to the candidate.

While the church is completely banned from participating in campaigns, the rule is that no “substantial part of its activities” may be the influencing of legislation, that is, it may do this to an insubstantial degree — which is not clearly defined in the law. But at least there is some leeway. There is no leeway as to the support of candidates.

The IRS has published guidance explaining its understanding of the rules. And see these FAQs as well. Now, a church may clearly state its views on moral issues with no concern for its tax-exempt status — unless it concludes with “and so you must therefore only vote for Republicans” or for or against candidate X.

Obviously this is tricky stuff, and there are plenty of reasons to be concerned — as some left-wing organizations are seeking to use these rules to silence right-leaning churches. Nonetheless, these are the rules whether or not your apply for a ruling from the IRS.

Incorporation?

I’ve never tried to obtain an IRS ruling for an unincorporated church. The instructions permit it, but there still has to be a written charter of some sort with the required language — which most unincorporated churches don’t have. Moreover, if state law doesn’t recognize the church as a legal person or entity, it can’t obtain tax-exempt status. As explained in the last post, many states treat a church as a special sort of trust, if not incorporated, and recognize the church as having legal existence. But the burden will be on the church to demonstrate this to the IRS.

In Alabama, an unincorporated church is governed by chapter 3B of title 10 of the Code of Alabama dealing with unincorporated nonprofit associations — and this statute requires written rules for how business is to be conducted. In the absence of a written set of governing documents (such as a charter and bylaws), the members run the church, not the elders or the men’s business meeting!

If you’re going to go to the trouble of drawing up documents, it might be easier to incorporate — unless there’s something in the nonprofit corporation statute that the church doesn’t want to be bound to. Either way, the key is thoughtful document drafting.

Conclusion

Any church that owns real estate should be incorporated or, if the state recognizes unincorporated nonprofit associates, should have formal organizational documents. Either way, the documents should carefully match the beliefs and practices of the church but without seeking to impose a creed on future members and leaders.

Any documents should also be drafted to meet the requirements of IRC section 501(c)(3) and the regulations under it — or else you won’t be tax exempt and donations to you won’t be deductible — whether or not you apply for an IRS ruling that you are a 501(c)(3) organization.

Personally, I don’t like the thought of having to document a church this way. Churches are living organisms, and their rules need to change as the church changes. They grow, they shrink, they learn, and they forget. Attitudes toward participation by women in church government can and will change. The method of ordaining elders will change. And most churches do just fine without a 75-page set of documents.

Therefore, in Alabama, I prefer to organize under a very minimal set of documents. (Yes, the lawyer prefers to stay away from legalities in a spiritually organized body.) But not all states will give you that option. And laying out the rules on paper doesn’t have to be a problem so long as you don’t just buy some lawyer’s forms. You need customized documents.

The bylaws have to be very carefully crafted to the needs of the church. And my advice is to keep the rules very minimal — focusing on modifying state law default rules that you don’t want to follow and giving the church great flexibility for how to operate — without having to hire a lawyer every time you appoint a new committee.