Safeguarding Church Leaders' Retirement: Legal Insights and Best Practices

The Importance of Adequate Retirement Planning for Pastors

Far too many pastors reach retirement age and can’t consider retiring—even if they desire to—because they do not have enough in retirement savings. Then there is the heartbreaking situation in which a pastor dies, leaving no viable means of financial support behind for the surviving spouse.

Common Issues in Church Retirement Planning

These problems unfortunately arise more often at churches across the nation than they should. Even more concerning: when a problem is discovered, the quick-fix solutions often proposed to resolve it are usually questionable, if not outright illegal.

There is a limit to what the church can pay. The most common reason for a church to lose its tax exemption is when the church is found to be operating principally to benefit an individual or individuals. This “private benefit” or “private inurement” occurs when the individual receives a benefit (compensation) greater than the value of what he or she provided (services) to the church.

Understanding Private Benefit and Private Inurement

The amount paid by a church to a pastor must be reasonable. This includes not just salary, but the contributions made by the church to a pastor’s retirement account. Unless there was a prior agreement between the church and the pastor to defer income to a later year (for example, the church agreed to pay the pastor $50,000 per year; however, because of a cash shortage, the church and pastor agreed to $40,000 cash and $10,000 deferred income to be shown as a liability to the church and paid to the pastor in the future, as appropriate), all of the funds will be considered to be earned in the year in which they were paid.

Private benefit. All assets of the church must be used for church purposes—to benefit the purpose for which the church was formed. If the church cannot provide a religious justification for a particular expenditure, it should not be made. The amount paid to each employee, including the minister, must be reasonable, and the primary purpose of any payment must be to advance the ministry of the church. If the primary purpose is to benefit an individual, this will endanger the tax status of the organization.

Private inurement. Private inurement is likely to arise when there is a transfer of church resources to an “insider” solely by virtue of the individual’s relationship with the organization, and without regard to accomplishing exempt purposes. An insider is one with a unique relationship to the church, by which the insider, by virtue of his or her control or influence over the church, can cause the organization’s funds or property to be applied to the insider’s benefit. There is no inurement when the benefit to the insider (or any other private party) is an unavoidable byproduct of actions taken for the church’s exempt purpose.

Intermediate Sanctions and Their Impact on Church Operations

In the past, if an exempt organization was operated in a way that benefitted a private person, the only remedy the IRS had was to revoke the exempt status of the organization. This often did not penalize the wrongdoer, but hurt the beneficiaries who no longer received services from the organization whose tax-exempt status was now revoked. In 1996, Congress changed the law by adopting a new provision (IRC section 4958) that imposes penalties on the person(s) who actually benefit from an improper transaction, rather than just revoking the exempt status of the organization. The result of this change is that if a “disqualified person” (defined as someone who is, or within the past five years has been, in a position to substantially influence the organization—and this will normally include the pastor) receives an “excess benefit” (for instance, more than the person is entitled to, based on what he or she provided to the organization), that person must repay the excess benefit (plus interest) along with a penalty of 25 percent of the excess benefit. In addition, if the excess benefit (plus interest) is not repaid in a timely manner, the IRS may impose an additional 200 percent penalty. Further, anyone who approved the benefit, even if he or she did not receive a dime (for instance, the board of directors), is subject to a penalty of up to $20,000 per transaction.

As a result of this law, which is commonly referred to as “intermediate sanctions”—since it is less than total revocation of the organization’s exempt status—it is even more important that the church take steps to determine that the compensation paid to the minister does not exceed what is reasonable (the value of services being provided by the minister).

What Constitutes Reasonable Compensation for Pastors?

What must be treated as compensation? Any benefit received by a disqualified person must be in exchange for some type of service or other benefit provided to the church by the disqualified person, and the church must treat it as such. Otherwise, it is treated as an excess benefit, without further consideration, and without regard to any claim of reasonableness of the total compensation package.

An economic benefit will not be treated as payment for the performance of services rendered by the disqualified person unless the church providing the benefit clearly indicates its intent to treat it as such when the benefit is paid.

Safe Harbor Provisions for Church Compensation

There are steps a church can take so that any compensation paid fits into what is sometimes called a “safe harbor.” This safe harbor provides that if certain requirements are met, then the burden switches from the individual to prove that his or her compensation is reasonable to the IRS to prove that the compensation is not reasonable. The safe harbor requires three steps:

1. Approval by disinterested board. The arrangement must be approved by a board or a committee of the board that is composed entirely of people who are unrelated to the person receiving the benefit, and not subject to his or her control.

2. Based on independent valuation. The board or committee must obtain and rely upon outside objective information to determine that an arrangement is reasonable.

3. Adequate documentation. The decision must be adequately documented and the basis for determining reasonableness clearly defined.

Conflict of Interest in Church Decision-Making

The church does not belong to the pastor. Although this might seem obvious, this point needs to be made. Many independent churches look to their pastor to lead and guide all aspects of the church. Often, the board itself is nonfunctional or acts as a rubber stamp for what the pastor decides.

When a director is making a decision on behalf of the church, he or she must look out for the church’s best interests. When a decision could benefit or harm the director personally, then the director is considered to have a conflict of interest. Limiting and regulating conflicts of interest is often addressed in the state law.

In conclusion, comprehensive retirement planning, coupled with adherence to legal and ethical standards, is crucial for securing pastors' financial well-being. By adopting proactive measures and engaging in informed decision-making, churches and pastors can navigate the complexities of retirement planning effectively.