Rent, Dressed as a Church Offering

Congregations that share their buildings with an outside organization face a compliance question most have never asked, and the answer does not depend on what the parties choose to call the money.

Every congregation sharing its facilities with another organization needs to be able to answer whether money received from that outside party is rent or a donation. The distinction marks the line between routine compliance and a liability that can attract penalties and the sustained attention of tax authorities.

For example, a congregation with more building than it can fill in a week may offer space to a guest congregation. Then, say, the guest congregation begins making regular monthly payments in return for the use of the sanctuary, the narthex, the audio and video equipment, the musical instruments, storage areas, a locked office, kitchen facilities, classrooms, and whatever else the host wishes to lend. Congregations participating in such an arrangement must resolve the purpose and distinction of the payments.

Classification Matters

Under the Internal Revenue Code, the distinction between a donation and a business payment is a substantive matter that congregations gamble with at their peril. Some congregations have failed to account properly for income received from the use of their facilities by third parties. When the matter finally surfaced, the accumulated tax, interest, and penalties exceeded anything the congregation held in reserve, so that the building itself became the only asset available to satisfy the liability. What is more, a congregation that loses its building in this way frequently loses the ability to conduct a final service in it, because by the time the sale closes, practical control has passed to a lender, a trustee, or an insurer.

According to settled IRS precedent, a donation is a voluntary transfer made out of “detached and disinterested generosity.” That formulation was supplied by the Supreme Court in Commissioner v. Duberstein, 363 U.S. 278 (1960). It is not made in exchange for goods, services, or access, and it must not carry the expectation of a quid pro quo. A rent payment, by contrast, is a regular and predictable remittance made in exchange for the use of the facilities. When the payor receives designated space, scheduled access, storage, equipment, and so on, the payment is classified as rent under the doctrine of substance over form, regardless of the label the parties may have agreed to place on it.

The Membership Problem

There is a further difficulty, and in most congregations it ought to settle the matter without any recourse to the tax code at all. The governing documents of a typical congregation restrict membership to natural persons, so that corporations, other congregations, nonprofit societies, scouting units, and sports leagues are ineligible by any construction of the constitution, however creative. Numbered giving envelopes exist because individual members, as natural persons, can make deductible charitable contributions that the congregation tracks and acknowledges for tax purposes, and the envelope system is the administrative instrument of that tracking.

A separately incorporated guest organization is not a member and cannot become one. However, some congregations in this position have been known to issue the entity with offering envelopes or giving statements that declare to the Internal Revenue Service or to any reviewing accountant that it is a contributing member in good standing. Such an arrangement treats a corporate entity as though it were a congregant dropping an offering into the plate, when in substance it is a tenant paying for the use of a facility. That incoherence is not a gray area but a category error visible on the face of any congregation’s own constitution.

What the Law Requires

Boards of trustees may assert that facility income becomes taxable only when the underlying property is debt-financed. That assertion is not simply wrong, which is what makes it dangerous: IRC § 514 does treat income from debt-financed property as unrelated business taxable income, and a congregation with a mortgage on the property it is leasing has a live problem on that basis alone. The error lies in treating debt financing as the only trigger.

Under IRC § 512, the threshold test asks whether:

1. the income derives from a trade or business,

2. whether that business is regularly carried on,

3. and whether it is substantially unrelated to the organization’s exempt purpose.

Regular occupancy by an unaffiliated organization will satisfy all three tests with little additional investigation. However, IRC § 512(b)(3) then generally excludes rents from real property from unrelated business taxable income, which is the reason many congregations may lease space without incurring federal tax. The exposure arises from exceptions to that exclusion:

• Personal property. The exclusion covers real property. When personal property is leased along with real property (audio and video equipment, musical instruments, tables, chairs, and movable fixtures are all deemed personal property), the exclusion is reduced or lost based on the share of the total payment attributable to that personal property. If that share is ten percent or less, it is treated as incidental and the whole of the rent remains excluded; if it exceeds ten percent but not fifty percent, the portion attributable to the personal property is taxable; and if it exceeds fifty percent, the entire payment loses the exclusion. A treasurer can run that calculation against his own equipment inventory this afternoon.

• Substantial services. If the host renders services for the convenience of the occupant beyond those customarily furnished with the rental of space, the payments cease to be rents for purposes of the exclusion and are instead treated as receipts from a service business. Staffed audio and video operation, custodial service, administrative support, and equipment setup all have to be considered.

• Profit-based rent. Where the amount payable is determined by reference to the income or profits of the occupant, and a payment calculated as a percentage of the guest congregation’s offerings is exactly that, the exclusion is unavailable.

• Debt-financed property. The § 514 rule remains in force whether or not any of the foregoing applies.

Consequently, the question a congregation must actually answer is not whether the building carries a mortgage, but what fraction of the payment is attributable to equipment, what services the host provides, how the amount was arrived at, and how the leasing agreement has been structured.

Moreover, the federal analysis is frequently not the largest risk on the table. State and local property tax exemptions commonly examine the actual use of the property for exempt purposes, and an assessor who concludes that a portion of the building is leased to an outside organization may withdraw exemption as to that portion without waiting for anyone at the Internal Revenue Service to take an interest. Congregations that have thought carefully about § 512 and ignored the county assessor have generally reversed the order of the real hazards.

Form 990 Is Not Form 990-T

A distinction that congregational leaders routinely misunderstand is the difference between the two annual tax filings. Churches are automatically exempt from filing the annual Form 990 informational return required of other 501(c)(3) organizations. That exemption is frequently taken to mean that a congregation has no federal filing obligation of any kind, which is false. When a church has gross unrelated business income of $1,000 or more in a taxable year, it must file Form 990-T and pay the tax owed, and the obligation is entirely independent of the Form 990 exemption. Where a congregation has been receiving what may amount to occupancy income for years without filing, each unfiled year stands as a separate compliance failure carrying its own penalties and its own accruing interest.

A congregation that issues an annual statement of contributions to an entity whose payments were not charitable contributions has produced a document the recipient may rely upon, and the substantiation rules of IRC § 170 together with the quid pro quo disclosure requirement of IRC § 6115 exist precisely to prevent that. Where a payment exceeds $75, and the payor receives goods or services in return, the organization must furnish a written statement disclosing that fact and providing a good faith estimate of the value received, and the penalty for failing to do so runs under IRC § 6714 at $10 per contribution up to $5,000 per fundraising event or mailing. The dollars are modest, but it creates a paper trail by which any misclassification can be traced and prosecuted.

Private Benefit and Excess Benefit

Members who raise these questions often cite private inurement, which has to be carefully tested as well. The excess benefit rules of IRC § 4958 impose an excise tax of twenty-five percent of the excess benefit on a disqualified person, rising by an additional two hundred percent where the transaction is not corrected within the taxable period. A disqualified person is one who was in a position to exercise substantial influence over the affairs of the congregation within the five-year lookback period, along with that person’s family members and controlled entities. Nevertheless, the analysis changes where a guest organization’s officers hold positions of influence in the host congregation, where the guest is treated as a sponsored mission of the host while simultaneously paying it, or where the record of trustee minutes shows that the guest’s requests are approved as a matter of course and its people move through the building at will. Trustees should further note that § 4958 reaches organization managers who knowingly participate in an excess benefit transaction, at ten percent of the excess benefit and capped at $20,000 per transaction, which is a personal liability rather than a congregational one.

Separately, a 501(c)(3) organization may not confer more than incidental private benefit on any private interest, and where the counterparty is a genuine outsider, private benefit rather than inurement is the operative doctrine. A below-market arrangement extended indefinitely to an unaffiliated organization is the classic occasion for private benefit analysis, and the congregation whose members are assured that the arrangement is unobjectionable because the guests clean the building has been given a housekeeping answer to a legal question.

What a Congregation Should Do

The path to compliance and a clean congregational conscience is not complicated.

1. Obtain a genuinely independent professional determination from counsel or a CPA with exempt organization experience and a signed engagement letter, who should determine whether any third-party payments constitute rent or contributions under applicable standards. Independence means the professional is not a member of the host or guest entity, not a relative of an officer, and not dependent on the congregation’s goodwill for anything.

2. Never issue numbered envelopes and annual contribution statements to any entity that cannot be a member of the congregation (i.e. a natural person).

3. Record all arrangements with legally vetted agreements that state the consideration, identify the real property and the personal property separately, specify which services the host provides, and set a term for the agreement.

4. Examine whether the guest organization uses the host’s address as its legal domicile on corporate or regulatory filings, since a congregation that has furnished another entity’s registered address establishes a conflicted relationship in the public records.

5. If payments should be reclassified as unrelated business taxable income (UBTI), file the amended and delinquent Form 990-T returns for all open years, report the income, pay the tax, and engage qualified tax counsel to consider voluntary disclosure. Voluntary disclosure is treated far more favorably than discovery on audit.

6. Ask the same questions of the state and local exemption, before the assessor asks them.

Ecclesiastical supervisors hold constitutional supervisory authority over the congregations in their charge, and questions of this kind fall well within it, so districts need to pay attention to building use arrangements with third parties. The orderly and faithful processes the Church has established do not include a process for ignoring federal tax law. Even so, the first point of responsibility is not the district office but the pastor, the officers, and the trustees.

This article is general commentary and not legal or tax advice. Congregations facing any of the questions described here should retain qualified counsel or an accountant with exempt organization experience.

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Cover Photo by Vitalii Abakumov on Unsplash