Churches, Taxes, and Nonprofit Treatment

Every so often, the issue of tax-exemptions for churches and religious organizations in the United States comes up and raises a bit of ire. Of course, at least for the time being, it usually comes up because of an occasional meme floating around Facebook and Twitter, and not because of serious attempts by those in government to call the tax exemptions of religious organizations into question.

But what about tax exemption of churches and religious organizations? Isn’t this unfair special treatment? Shouldn’t pastors have to pay taxes on their income?

My goal here is to explain a bit about tax exemption for religious organizations, clear up a few misunderstandings, and hopefully improve the conversation about how to handle taxes and religious organizations by getting us all on some common understanding about the situation.

The first thing to note is that when we talk about tax-exemptions for churches and other religious organizations, really two different tax statuses are at play, not just one.

Tax-Exempt Status: Tax-Exemption At The Entity Level

The broader category of tax exemption applies at the entity level. And in this regard, there is nothing special about churches and religious organizations at all. Many kinds of organizations fit the requirements are tax-exempt. Others include secular charities, universities, political organizations, Elks lodges, sports leagues, labor unions, fraternal societies and many other kinds of organizations. It is not a matter of privilege for churches but simply fair treatment (although the Constitution does arguably create a degree of privilege due to the First Amendment’s protection of religious freedom). To not give them tax-exemption at the entity level would be to discriminate against these organizations specifically because they are religious.

What then does it mean for an entity to be tax-exempt? This tax-exemption means that an organization that is tax-exempt does not have to calculate income and pay taxes on it like a for-profit business. A normal business takes in money (revenue) in exchange for goods and services, subtracts money paid out in the course of business (expenses), and if revenue exceeds expenses, the business has earned a profit (net income) and pays an income tax on that net income. How this plays out depends on the type of business entity (sole proprietorship, partnership, corporation, etc.), but you get the idea. Tax-exempt entities, however, do not pay taxes on this net income.

Why do tax-exempt entities not pay taxes on that income? The general rule is that these organizations do not exist to earn a profit, and profits they do earn stay in the organization instead of being paid out to owners or stockholders. These organizations don’t even have owners or stockholders to give profits to in the first place.

For a normal business, there is an owner or owners/stockholders who are entitled to the net assets of the company and the net income earned. If a corporation has a great year and earns huge profits, those profits can be paid out to the owners (stockholders) in the form of dividends. For a not-for-profit entity, there are no stockholders. You can’t buy or sell a share in the organization. The assets and income don’t belong to you or anyone else. They have to stay with the organization itself, and there are laws about what such organizations must do with net assets (after they pay their debts) if the organization dissolves. And if a nonprofit organization were to start paying out large amounts of its net income to interested parties (beyond the extent of reasonable wages for services rendered), kind of like a for-profit business paying dividends to its shareholders, the organization could potentially get in trouble with the government and even lose their tax-exempt status.

All that is to say that there is criteria for being tax-exempt at the entity level, and churches and religious organizations generally meet it (there are explicitly for-profit religious organizations that pay taxes but that is another story). So even apart from any argument in favor of granting them special privileges on First Amendment grounds, as some do, exempting a nonprofit entity like a church from business income taxes just makes good sense based on the rules in place. To argue that because they are religious they should not get the tax benefits that other similar organizations get is to actively discriminate against them, not simply decline from giving them special privileges.

Additional Tax-Exempt Status: Tax-Deductible Contributions to the Organizations

Now, there is an additional tax benefit beyond just tax exemption that religious organizations can use, and this benefit is more limited (although it still applies to many types of secular organizations as well).

Churches and religious organizations can receive an advantage reserved specifically under the Internal Revenue Code §501(c)(3). You have probably heard the term “501(c)(3)” before, and this is what it refers to. If you donate to an organization under IRC §501(c)(3), not only does the organization not have to pay income on its net proceeds (donations minus expenses), but those who make contributions get to deduct the money they donate from their taxable income (subject to several limitations). Since income tax in the US is based on taxing percentages of your taxable income, the lower your taxable income is, the less tax you have to pay. This reduction in taxable income helps make up for some of the cost of donating to the organization, and this encourages people to donate. This, in turn, benefits the 501(c )(3) organization by increasing donations to them.

For example, let’s say somebody donates $1,000 to a 501(c)(3) organization. They can deduct that $1,000 from their taxable income. If their marginal tax rate is 25%, they would have paid $250 in tax on that $1,000 had they not deducted it. This means that they get $250 back on their taxes because they donated. As a result, that $1,000 donation really only cost them $750 ($1,000-$250). So if they only had $750 to give, they could give $1,000 due to the tax benefit. This means the organization got $250 than they otherwise would have. That is a pretty useful tax benefit for an organization that depends on donations.

Religious organizations are specified under IRC §501(c)(3), so if you are a church or a synagogue or mosque or theology organization or whatever else, you can apply for 501(c)(3) status and donations to you can be tax-deductible to those who give.

Now, this benefit is not only reserved for religious organizations. IRC §501(c)(3) is one giant sentence, but it also includes educational organizations (e.g. universities), amateur sports (e.g. kid’s soccer), charities (religious and secular), organizations that pursue scientific research, and organizations that exist for the prevention of cruelty to animals. The basic idea being, if it is an organization that in some manner is used to benefit public welfare, people should be encouraged by the tax code to donate to them.

Here, one might argue that even if religious organizations should have tax-exemption out of fairness, it should not get this special designation. Fairness does not require it to the extent that it requires simply tax-exemption at the entity level.

That said, I think the benefits of IRC §501(c)(3) are broadly applied enough that it makes sense to include religious organizations. Contrary to popular belief, the 501(c)(3) benefit is not only for charities that feed the hungry and clothe the poor (although many churches and religious organizations do that as a part of their work). Because it applies to all sorts of entities that can have a broader, less defined benefit to society (like kid’s sports or a university that teaches some person I don’t know about classical philosophy), religious organizations would seem to fit the bill.

One might argue that because religion is controversial, and different religions conflict in their teachings, religious organizations broadly should not be considered beneficial to society, even if one religion is actually true. However, with other organizations and causes, there is no requirement under the code that entities all teach the same things or do not conflict with each other in their beliefs or even in their actions. That is why conservative and liberal universities alike are covered. That is why Feminists for Life and National Right to life are 501c(3) organizations but so is Planned Parenthood. And that is why even pro-atheism organizations like American Atheists and The Freedom from Religion Foundation are 501(c)(3) organizations with all the same tax benefits as everyone else here. The tax code lets the different, conflicting groups all have the tax benefit and lets the people decide whom they think is worth donating to.

It Is Not True That Pastors and Clergy Are Exempt From Paying Taxes

Some people think that pastors do not pay taxes, but that is simply inaccurate. Like the employees of any tax-exempt entity, their income is still subject to income tax like everyone else’s.  Insofar as the money taken in by tax-exempt organizations is paid to employees, that money is taxed in the form of individual income tax levied upon the employee who earns it. Money just isn’t taxed at the organization level when the organization earns it (as it would be in a for-profit corporation).

Now, because of the unusual nature of a clergy job (not just Christian), there are certain tax provisions that apply specifically to them. And there can be some benefits to this. For example, for some clergy (not just Christian), sometimes a church or similar entity can provide housing or a housing allowance, subject to limits, and the clergyman does not have to report this as taxable income. Clergy are not the only sort of employee who get some form of employer-covered housing that is not subject to income tax, but this is certainly a great potential tax benefit to being a pastor.

Despite some benefits, pastors do still have to pay income taxes like everyone else. So while a handful of charlatans may make millions of dollars by lying to people in the name of religion, they still have to pay taxes on it – no matter what those memes you saw on Facebook say.

Churches are tax-exempt. Pastors are not.

Churches and Religious Organizations Actually Do Pay Some Taxes

Churches and religious nonprofits can get out of income tax at the federal level and probably in most (if not all) states. However, they may be subject other forms of taxation common to businesses.

For example, most religious nonprofits have to withhold and remit FICA taxes (Social Security and Medicare) and also pay a matching amount on their employees’ behalf, same as every other employer. Churches specifically have some unique rules when it comes to FICA, but most will have to at least pay the standard employer portion of FICA taxes for any non-minister employees.

Churches and religious nonprofits may also be subject to sales tax and other taxes levied at the state level. As you might imagine, this varies by state.

Nonprofits, including churches, can also potentially owe tax on what is called unrelated business income (UBI). In a nutshell, if a nonprofit engages in a trade or business beyond what is incidental to their mission, they may be required to pay taxes on the income earned. This doesn’t come up too often with churches, as there are exemptions and threshold requirements (the first $1,000 of otherwise taxable UBI is not taxed). But a nonprofit cannot create or buy a business arm and expect to be able to engage in that trade with no taxes. So a church couldn’t create a clothing line or buy an ice cream shop and expect to not have to pay taxes on what is clearly business income.