Transparency In Ministry

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As churches outgrow their facilities and either expand their current facility or build on a new site, many are faced with “how to” finance their growth. Growth will either be financed internally, (no external debt) or externally (debt with a third party). Many churches may be blessed to save thousands or dollars over time and have money invested for the long-term. However, some churches are faced with no space and need external funds to finance immediate construction. If construction is financed with debt, (e.g, a note from a bank), the interest that is incurred is considered a component cost of the construction. Or simply, the cost of the building includes more than just labor, materials and overhead. Interest cost shall be capitalized as part of the historical cost of acquiring certain assets. To qualify for interest capitalization, assets must require a period of time to get them ready for their intended use. (FAS34).

How is interest calculated and recorded….coming up later….

How To Capitalize Interest as a Construction Cost

As construction begins on a facility, many churches finance the costs with external debt. The debt is not free since interest is paid periodically to the bank. The interest is also a cost of the construction of the asset and should be capitalized as part of the cost of the facility. The facility cost, including capitalized interest, is then depreciated over the estimated useful life of the asset – 40, 50, 70 years, or more.

To qualify for interest capitalization, assets must require a period of time to get them ready for their intended use. (FAS34). Interest shall begin when three conditions are met:

1. Expenditures have been made.

2. Activities are in progress to get the asset ready for its use.

3. Interest cost is being incurred.

The amount capitalized during the accounting period is determined by applying the interest rate to the average amount of accumulated expenditures for the asset during the period. In order words, calculate the average “accumulated” expenditures for the year (PY accumulated total + CY accumulated total)/2 = average x interest rate of related debt or designated borrowings. This additional cost, is considered “capitalized interest” for the period and should be added to construction in progress.

Easy….sometimes not. For a simplified excel file, see >>>>>>>

For more information see FASB Statement 34; FASB Statement 42; FASB Statement 58; FASB Statement 62;
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Most churches and ministries believe everything they do is part of their overall mission to further the work of Christ. Therefore, there couldn't possibly be anything unrelated about their operations...or could there?

Many organizations operate book or music stores, concession stands, coffee shops, or teen game rooms. They may sell advertising spots in a magazine or rent space in their building. So they may, unknowingly, have unrelated business income subject to tax.

Let's look at how to determine if your organization has an issue.

We can first eliminate many activities because unrelated business taxable income (UBIT) does not include:

(1) Activities in which substantially all the work is performed by unpaid volunteers,

(2) Activities primarily for the convenience of members, students, or employees, or

(3) Selling merchandise received as gifts or contributions.

Many activities such as bake sales, thrift shops, car washes, and fundraising dinners are exempt due to these three exclusions.

If the activity does not meet any of these exceptions, there are three additional tests to consider, which we will cover in our next UBIT update...

Maybe We Do Have UBIT

If your exempt organization is making money other than from contributions, you need to consider the possibility that you have unrelated business taxable income (UBIT). In our previous blog, we listed three easy exceptions. Activities that don't pass those exceptions need to consider the following three tests.

First, look at whether or not the activity is a business. Generally, this is any activity carried on to make a profit from the sale of goods or services.

Second, determine if the business is regularly carried on. The purpose of the unrelated business income tax is to place an exempt organization’s business on the same tax basis as that of any taxable entity with which it competes. If a taxable entity would carry on a restaurant year-round but the exempt organization only operates a sandwich shop for one week, the business is not regularly carried on. An activity carried on only one day a week but on a year-round basis is considered regularly carried on.

Third, decide if the conduct of the business is related to the performance of the charitable, educational, or other exempt purpose of the organization. The organization’s need for income and how they spend the profits are irrelevant-this does not make it a related purpose. The business activity must contribute importantly to the accomplishment of an exempt purpose. Consider the size and extent of the activity in relation to the nature and extent of the exempt function that it serves.

Need an example? More to come….

So what types of receipts affect UBIT???

The sale of religious publications or sermon tapes is generally related to the exempt purposes of a church. A bookstore is a little trickier.

We can eliminate any bookstore that is:

(1) Run by unpaid volunteers

(2) Provided only for the convenience of church members, or

(3) Selling only merchandise received as contributions.

We will assume the store is operating to make a profit and is open year-round. Therefore, if it does not meet one of the above exceptions, decide if the conduct of the store is related to the performance of an exempt purpose of the organization – such as education and training. The operation of the bookstore must contribute importantly to the accomplishment of that purpose.

Look at the location of the bookstore (is it inside the church?), sales of non-religious items (like pens or film), and hours the store is open.

Also, does the store conduct advertising and open its doors to the general public?

The tax may be imposed to eliminate the unfair competitive advantage the nonprofit organization would enjoy if they could sell products to the public in direct competition with taxable enterprises selling the same or similar merchandise.

Obviously, there is not one easy answer to this question, but hopefully this education will assist you in knowing what items to look for in evaluating your business activities.

In typical legislative style, the Oklahoma Legislature passed, and then inadvertently repealed, and then promised to pass again, a bill exempting church construction contracts from OK sales tax. Normally, churches are exempt from OK sales tax. However, if a church undertakes a construction project and hires a contractor who purchases the materials, the contractor has to pay sales tax on the materials. The contractor would naturally pass through this tax in his billings under the contract. Oftentimes, a church will arrange with its contractor for the church to pay for materials directly, thereby avoiding the sales tax burden. This can be a cumbersome process. Enter the OK Legislature riding its white horse...

The bill, SB 1084 - the Omnibus Tax Bill, provided a sales tax exemption for "any person with whom a church has duly entered into a construction contract..." What a great idea! However, in its Special Session the Legislature repealed the entire tax bill and forgot to put this exemption back into the final bill. To add to the confusion, the repeal is not effective until June 30, 2007, whereas the original exemption is effective August 25, 2006. What this means is material purchases by the contractor between August 26, 2006 and June 30, 2007 will be exempt from OK sales tax. If the Legislature fixes its mistake, the exemption should continue. If the error is not rectified, the exemption will expire on June 30, 2007.

Recommendation: The prudent course for church construction contracts may be for the church to continue to pay for the building materials directly until the OK Legislature gets its act together. Updated information will be forthcoming as soon as the Legislature moves. For other state filing requirements...We have answers...contact us!

A pastor has special clothing or uniforms that are worn during television broadcasts. The church pays for the clothing or wardrobe and the pastor would like to keep the clothing at home instead of the television studio. Are these uniforms a legitimate expense of the church …and is it permissible to maintain the clothing at the pastor’s home?

The general rule is that the cost of clothing of an employee is deductible (and presumably can be provided tax-free by the employer) if both of the following tests are met:

...if the uniforms are specifically required as a condition of employment, and
...the uniforms aren't of a type adaptable to general or continued usage to the extent they take the place of regular clothing. Revenue Ruling 70-474, 1970-2 CB 34.

The Tax court (Yeomans v. Commissioner, 30 T.C. 757 (need link).applied an additional subjective test, which examines the suitability of the clothing for private or personal wear by the taxpayer seeking the deduction. In other words, the clothing must meet three criteria:

1) The clothing can't be suitable for general or personal wear;
2) It must be required or essential in the taxpayer's employment; and
3) It isn't, in fact, used for general or personal wear.

A case decided in 1966 (Nelson, Oswald, TC Memo 1966-224) allowed an actor to deduct clothing even though it was suitable for general or personal wear. The deciding factor in this case was that the clothes were kept at the studio, and never worn outside of the TV set.

So to answer the above questions..Are uniforms/specialized clothing a legitimate expense?? Yes, if the uniforms used by the pastor are required as a condition of employment. These benefits are provided “tax-free” to the pastor.

Can the uniforms or specialized clothing, not adaptable to general usage be maintained at the pastors personal residence? YES…based on the reasoning provided by the Nelson case. If the pastor takes the suits home, he would have to prove that the suits were not suitable for general or personal wear.

However….(there’s usually one in every case…) While there may an argument that the suits are not suitable for personal wear, the question is a subjective one, and could ultimately be decided by a court that has a difference of opinion than that above. The safest and most prudent course of action is to continue to keep the suits at the studio so that there is no question that the suits are not worn for personal use. And, of course, the issue as to suitability for personal wear remains moot if the suits are left at the studio.

A pastor would like double-breasted, black suits for special television events. He did not wear these suits in his private life and he maintained the suits at his residence. The church did not pay for these suits, but the pastor incurred these costs and wants to know if this is a business expense, deductible in his personal tax return?

In Hynes v. Commissioner, 74 TC 1266, the taxpayer-petitioner, a TV newscaster, contended that he was entitled to deduct the expense of his on-the-air wardrobe that he kept at home because he was restricted in his selection of colors and patterns of such clothes and because he did not wear the clothes when he was not at the station on camera. The court did not agree with his contention and observed that "the restriction on the petitioner's selection of his business attire is not significantly different from that applicable to other business people who must limit their selection of business clothes to conservative styles and fashions. The fact that the petitioner chose not to wear his business clothes when he was away from the station does not mean that such clothes were not suitable for his private and personal wear. Indeed, most people do not wear their business clothes at home."

In Gerres v. Commissioner, TC Memo 1986-573, the petitioner was a welder and, as such, purchased fire resistance clothes. The Tax court ruled that the clothing was suitable for general wear and disallowed the deduction, even though the petitioner testified that he only wore the fire resistant clothes at work.

Answer…specialized clothing that is suitable for private/personal wear, maintained at home is not a business expense…other professionals do not get to deduct the costs of the suits worn in the corporate world.

A pastor purchases selected shirts and pays to have the ministry logo embroidered on the shirts. He wears the ministry shirt in the performance of his duties and the cost is not reimbursed by the church? Is this a legitimate business expense deductible on his tax return?

The fact that church or ministry logo is embroidered on some of the shirts may help in the argument that (at least for those shirts), the suits are not suitable for private and personal wear. In Levitt v. Commissioner, TC Summary Opinion 2001-147, petitioner testified that he was required to purchase and maintain tuxedo shirts with a company logo. The tax court ruled that the petitioner "satisfied the elements under Yeomans v Commissioner (cited in earlier posting), supra; therefore, he is entitled to a deduction for the costs of the .....shirts." In the same case, the Tax Court disallowed the deduction of black shoes required by the employer because they were suitable for general or personal wear. In Risicato v. Commissioner, TC Memo 1984-238, the Tax Court examined whether or not a "jacket with a business identification on it constitute the sort of work clothing that is properly deductible." It concluded that "the purpose of the jacket was to advertise and identify petitioner's business" and concluded that the jacket was deductible.

Answer...yes, it is an allowable business deduction, if not reimbursed by the Church.