Trap #4 Operating in the IRS and State & Local tax worlds without knowing the rules. (Part 2)

Many churches ignore or do not understand what unrelated business income is. 

Very often one of our church clients will call us concerned that they have received unrelated business income.  The vast majority of the calls are concerned with the sale of an asset or the rental of their facilities.  After giving me the details of what they have done they usually ask,  “Are we going to lose our tax exemption?”

In most cases the answer to this question is no because the purpose of the unrelated business income tax is not to punish exempt organizations who engage in unrelated activities.  The main purpose is to simply collect taxes!  Unless an unrelated activity becomes so large that it is the dominant activity a charity is engaged in, tax exempt status is safe.

The best way to understand the rules is to look closely at the words unrelated and business.  Unrelated means activities not directly connected with a church’s defined mission or purpose.  So, in the case of casual sales of property, the church has definitely received some “unrelated” income.  But, we need to look at the second word, “business”.  This word implies that an activity is regularly carried on.  In other words, the church is holding itself out as operating a business on an ongoing basis.  Very few churches generate this type of income.  A few examples are restaurants that are open to the public and parking lot and garage fees. 

Rents, by definition are NOT considered unrelated business income, unless the church happens to be renting a facility that was purchased with a mortgage.  Even then, there are a myriad of loopholes that may allow the church to escape taxation.

But, even if a church does generate unrelated business income, there is nothing to worry about unless the activity dwarfs the church’s main exempt purpose.  The tax code is simply trying to level the competitive playing field.  If a church is entering the market place, it should have to pay taxes just like its competitors.

Trap #3 Operating with little or no accounting controls (Part 2)

Many churches fail to implement a well defined purchase approval and payment system

There is a great difference in attitude in the church environment between receipts and disbursements.  While churches exercise extreme vigilance over the “inflow” of funds into the church, many have a rather cavalier attitude towards the “outflow”.

Churches also tend to rely on a few “fraud prevention” methods which in my opinion provide little more protection than a security blanket.  They may give a warm and fuzzy feeling, but are no help in a real crisis.  The two I hear most often are the requirement of dual signatures for checks over a predetermined amount and the requirement that a check request form be filled out before anyone gets paid.  It is not uncommon for these to be the only two “fraud prevention” controls exercised over cash disbursements.

KEY: Churches that rely on methods this simple are unaware of two basic facts.  First, dual signatures and homemade check requests are absolutely no match for an ethically challenged employee with the courage to forge.  Second, and this may be the most surprising, many of the larger and more spectacular embezzlements involve tampering with the church’s cash outflow, not the inflow.

An important element of proper stewardship is to develop, implement and live by a well defined, written bill approval and payment process.  Some key ingredients of such a plan:

 A clear description of who will:

           Approve bills

            Receive goods

            Validate invoice with purchase order and receiving documents

            Prepare checks for payment

            Sign checks

            Mail bills

            Record transactions in the general ledger

Use of pre-printed, sequentially numbered purchase orders, not check request forms that anyone can duplicate on a copy machine.  

A vendor application and approval process culminating in an approved vendor list

Write checks and/or make drafts only to vendors on the list

Consider using a Positive Pay program in partnership with your bank.

Trap #3 Operating with little or no accounting controls

Because of staff size many churches have poor segregation of tasks

 

Next to the absence of well-defined, written accounting and management policies, the most common weakness we have noticed in churches is the lack of adequate segregation of duties.  In other words, the accounting tasks are not spread out among enough individuals.  This is usually due to budget constraints, as churches tend to fund ministries first, then whatever is left is applied to administration.  Whenever possible, accounting tasks, particularly those involving cash transactions, should be divided between several individuals to limit the possibility or even the appearance of the misuse of funds.  There are two main purposes for developing a strong segregation of tasks:

First, strengthening the accounting control system protects the Church from the misuse of funds and loss of assets. 

KEY: Second, proper segregation of duties protects Church staff and volunteers from unwarranted charges of impropriety.  In my opinion, this is the most important reason for spreading the work around as many people as possible.  We must never forget that in volunteer organizations, the appearance of improprieties can cause as much or more harm than actual occurrences of theft or embezzlement. 

All churches should investigate ways to protect itself and its staff by finding methods to segregate as many of the accounting duties as possible.  Here are some of the weaknesses we have seen in segregation of duties:

Often a church’s offering count teams are made up of the same individuals who perform the task week in and week out.  Action Step: Make an effort to enlist as many people as possible to serve as tellers.  Also, include a planned rotation of the counters 

Many churches on Sunday mornings, store their offerings overnight in a safe that does not require dual access.  Action Step: When money remains on Church premises for over twenty-four hours, use a safe that requires the participation of two individuals to unlock.  (A less expensive way to do this is use lockable or tamperproof bank bags and assign separate custodianship of the bags and access to the safe)   

By far the most common weakness is the habit many churches fall into of allowing the church financial secretary/bookkeeper to be involved in every aspect of the accounting process, particularly those involving cash.  Action Step: The church bank account is the “Grand Central Station” of a church’s business activity. One of the most effective steps that can be taken to provide segregation of duties is to remove the bank reconciliation task from the bookkeeping department and assign the work to another employee or volunteer.

Trap #2 Operating without a compensation plan (Part 4)

It’s so difficult to say goodbye – firing right

Churches should follow prudent steps in firing employees.  This begins by making sure that the termination must be for a legitimate, nondiscriminatory reason.  Prior disciplinary measures must be consistent with church personnel processes and policies

The first step should be to schedule a meeting that includes the terminated employee, the employee’s supervisor, the church HR director or supervisor’s manager and the church’s legal counsel. (If considered necessary.)

First and foremost, the church should make it a goal to preserve the employee’s dignity.  Keeping the meeting as brief as possible contributes to achievement of this goal. A concise explanation to the employee of the reasons for termination should be given along with a carefully documented history of the issues.  That is why the performance reviews mentioned in our previous post are so important.  Having a documented case history prevents the employee from asserting they were never informed.

KEY: Do not let the employee drag the process into an argument!

If severance pay is offered to the employee, discuss the terms of the severance with the employee.  Church property including passwords, office equipment should be collected from the employee by providing the employee with choices of when he or she may pick up personal belongings.

Also, unused benefits, unpaid expense reimbursements, and written permission in regard to references should be addressed.

KEY: In some cases it may be better to deem the termination a resignation, especially in the absence of animosity.  It is another way for preserving the employee’s dignity

Trap #2 Operating without a compensation plan (Part 3)

Happy together; managing your employees

The best way to avoid mistakes in hiring and in firing is to employ simple, repeatable processes to help insure that the right things are done at the right time.  One way to do this is to develop a “New Hire Packet” which should be given to each new employee.  Some of the items that should be submitted to each employee are:

KEY: A copy of the official church employee manual

A form W-4 to be completed by the new employee

A form I-9 (Department of Labor requires all I-9s to be filed in a stand-alone file)

In addition to providing new hires with relevant forms, the church should maintain a separate file for each employee.  Personnel files should be kept in a secure location and it is a good idea to store active and inactive personnel files in separate locations.  Medical information must be kept in a separate file from the regular personnel files in order to be in compliance with the Americans with Disabilities Act.  Other confidential information that should be kept separately includes the I-9, grievance and investigation records, and garnishments and loans to employees.

In addition, personnel files should include the original application form submitted by the employee, a signed W-4 and a copy of ministerial credentials for all employees hired to serve as ministers. (Ordination, licensing or commissioning certificate.)  This is not mandatory, but rather a “best practice” insuring that church ministers are treated properly for income tax purposes.  Paycheck deduction authorizations signed by the employee should also be retained and updated. 

KEY:  Finally, a record of performance reviews, evaluations and reprimands must be maintained on a current basis.

KEY: Many churches keep up with all of this paper work by using a personnel file checklist which assists in making sure all t’s are crossed and i’s dotted.

Trap #2 Operating without a compensation plan (Part 2)

Getting off on the right foot – hiring right

One way to avoid unhappy situations is to begin on the right foot.  And in personnel matters, that means hiring right.  Churches should follow prudent steps in hiring their employees.  For starters, a church must know what it is looking for in a new employee.  That means that job descriptions should be prepared prior to the interviewing process. 

Once that is done, a church can then begin recruiting and evaluating potential employees.  Here are a few tips to guide churches in the recruiting process:

  • Maintain a record, in writing, of all job openings.
  • Keep a file of the various advertisements it has placed to recruit applicants.
  •  Utilize a standardized applicant screening and interviewing process, making sure that managers are properly trained in the conducting of effective and legal interviews.
  • Utilize a standard application form which informs applicants of the terms and conditions of employment. (Particularly the right to consider their religious affiliation.)
    • The application should avoid unlawful pre-employment inquiries. (Age, race, sex,. etc)

KEY: The application should be reviewed by the church’s legal counsel prior to being used in the hiring process.

Trap #2 Operating without a compensation plan (Part 1)

The second trap, or thing to avoid, deals with payroll.  Churches face risk in a variety of areas.  Facilities, congregational unity, financial, security, and our next topic, personnel are just a few areas of danger.

In business terms, churches are in the “service industry” and as a result, typically, 50% of church budgets are dedicated to salaries and benefits. Personnel risk is significant. Operating in the personnel arena without a formal plan makes it even riskier.

Unfortunately, some churches do exactly that.  Here is what has happened to some of those who chose not to manage personnel risk:

  • Churches have been sued (and lost) after automobile accidents in which it was discovered the church assigned driver had a prior DWI.
  • Churches have been sued after discovery of prior child abuse convictions of some of their employees.
  • Churches have been victimized by embezzlers with prior convictions.
  • Churches have been sued for unlawful terminations.
  • Churches have been sued for sexual harassment.

In the next few posts, we will discuss things that should be done in order to avoid situations like these unfortunate churches.  It’s important to point out that they were unfortunate primarily because they were careless.

Trap #1 Operating without a plan – Long-term plans (continued)

Today we continue our discussion of the importance of long-range planning by looking at two other areas where churches need to be taking soundings, to see if storm clouds are on the horizon.

Ignoring long-range giving opportunities

At the present time, our society is going through the greatest asset transfer in world history.  Many of the baby-boomers, who have lived through the most prosperous eras of our nation’s history, are reaching retirement age.  With ever increasing amounts of disposable income many are also looking for worthy charities to share their abundance with.

Many pastors are surprised when they read in the newspaper or online that one of their members has given a substantial endowment gift to the local university or hospital.  Some pastors screw up the courage to ask why the church was not the beneficiary only to hear the following comment.  “You never asked.”

Whether churches like it or not, they live in a competitive arena.  Various organizations within the nonprofit sector are vying for a limited amount of donor dollars.  Churches also need to realize that secular charities are asking their members for significant gifts.  Maybe the churches should too…

When it comes to fund-raising, few churches look past current budget needs or an occasional building campaign.  Very few venture into the planned giving arena.  Perhaps it is time to begin.

Failure to address demographic change in the church’s mission field

In the last few decades, immigration has drastically changed the demographic makeup of our nation.  In the course this major shift, neighborhoods have taken on a new look and culture.  Unfortunately, many churches failed to adapt to their surroundings, and as a result, have seen a dramatic decline in membership.  In fact, many have ceased to exist.

Because most of these churches are in older parts of most cities and towns many church leaders in the growing areas feel somewhat immune to this situation.  I think this is a false sense of security.  I am getting old enough now to have seen quite a bit in my career providing services to churches.  One thing I have noticed is that churches do indeed have a cycle they follow.  Eventually, the new becomes old and almost all churches must re-evaluate their situations.  It is essential, to be an effective ministry present, each church must evaluate its calling.  One way to do that is to have a firm understanding of its surrounding neighborhoods.  By paying timely attention to these matters, churches can adapt their efforts and provide ministry to their new neighbors. 

Trap #1 Operating without a plan – Long-term plans

Because of dependence on the Whack-a-Mole management strategy, many churches seldom look past their current situation.  Unlike ancient sailors who took periodic “soundings” to determine how close they were to shore, many churches take few, if any steps, to determine if they are headed for rocky waters.  Unfortunately, a rising number of them do not realize they are in trouble until they run aground.

It is true that the Bible cautions us to not presume on the future. (James 4:13-15)  But, churches are also called to be good stewards.  As long as the church is acknowledging God’s will in the matter, part of good stewardship includes making some long-range plans.  Failure to do so could result in disaster.

Operating without a master plan in regard to land and facilities

Several years ago at one of PSK’s church business administrator breakfasts, we invited the local fire marshal to speak on fire safety.  He mentioned one thing that surprised me and another thing that made me think of the importance of master planning.

The surprise?  Other than petroleum or chemical fires, the fires feared most by firemen are church fires.  Because churches are filled with combustible items, paper, wood, fabrics etc. a small electrical problem can quickly ignite into a raging inferno.  But what he said next made me realize that poor master planning can be deadly as well. 

How does this tie into master planning?  The factor that endangers firemen the most is not the presence of combustibles. It is the fact that too many churches are a hodge-podge of different structures.  Without an integrated building plan which looks to the future, church structures tend to become a series of additions added one to another.  The result is a confusing maze of hallways, cubbyholes and dead-ends. (Tragically, in some cases this has been too literal).

This can be avoided if churches take the time to plan for the future.

Trap #1 Operating without a plan – Short-term plans (continued)

Operating without a formal, written accounting and management policy manual

In addition to a budget, a formal management document is a must to help insure that the church makes appropriate and effective short-term decisions.  Written policies and procedure documents assist churches in the administration of activities by helping to set forth in clear, unmistakable terms the mission of the church and how it will be carried out.  The manual will also establish and reinforce the organizational structure of the church by providing a clear delegation of duties and responsibilities.  It also will serve as a guide to direct and oversee the carrying out of Church activities.

One of the purposes of written policies is to head off problems before they arise.  And, in cases when problems do arise, having policies in place makes navigating the choppy waters manageable.  For instance, suppose your church is offered a gift of land of a sizeable dollar value. (According to the donor…)  The church accepts the land, transfers the title, and later learns the land has significant environmental issues.  (For example, the land was the site of a former gas station, dairy, or dry cleaners, etc.)  Unfortunately, accepting the land also results in accepting the liability for cleaning up the mess.  A good contribution policy could help prevent this from happening by requiring all gifts of property be approved by the appropriate committee prior to acceptance.  Contribution acceptance is just one of the topics to be included in a policy manual.  Here are a few more.

Organizational structure

Budget development

Cash management

Offering counting, recording and reporting

Bill approval and payment

Vendor approval

Investments

Financial statement presentation

Personnel and employee benefits

Insurance

Conflicts of interest

Fundraising

Building and property use

Restricted funds

Intellectual properties

Short-term mission trips

KEY:  A church accounting and management policies and procedures document is another brick in the wall of risk management.  The goal of establishing clear policies is to anticipate problems before they arise and having a suitable response should they occur.

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