How to Ensure Tax and Accounting Compliance for Your Church

Are you managing tithes properly? Are you compliant with tax-exemption requirements? Many church bookkeepers lose sleep worrying that their church will lose its tax-exempt status and face penalties for non-compliance. In this article, I’d like to help you overcome these concerns.

I’ve been doing tax and accounting work for churches and nonprofits for 20 years and will provide tips and advice in this article that help you keep your church compliant with IRS regulations and accounting best practices. By following these church accounting guidelines and best practices, you can accurately and properly track income and expenses for your church and avoid losing your tax-exempt status.

Bad church accounting damages more than your tax-exempt status

Proper accounting practices are the bedrock of a church's financial health and longevity. While many religious organizations emphasize their spiritual mission, neglecting the financial side of church programs can lead to dire consequences. Poor accounting not only jeopardizes your church's tax-exempt status but also erodes its financial stability and undermines your ability to serve the community effectively.

Some consequences of poor accounting practices

• Improper church bookkeeping causes costly penalties: Imagine discovering your church owes thousands in back taxes due to improper church bookkeeping. This nightmare scenario has become a reality for many religious organizations that failed to maintain accurate financial records.
• Mismanaging funds reveals bad stewardship: It’s vital that your church properly implements fund accounting so you can understand how funds are being used and the amounts that remain. 
• IRS scrutiny eventually catches up to you: While churches are considered tax-exempt, they do have reporting requirements and tax obligations for unrelated business income. If these requirements are not fulfilled, the IRS will revoke your church’s tax exemption.
• A lack of internal controls makes fraud easier: In recent news, a church bookkeeper was convicted of stealing $775,000 under the guise of a church construction project for a new youth center. Such fraud becomes more convenient when proper internal controls are not in place.

How to protect your tax-exempt status and demonstrate financial stewardship

Good church accounting and tax compliance is not just about adhering to legal requirements related to your tax-exempt status but also about demonstrating responsible financial stewardship to your congregation and community. Here are my recommendations for fulfilling your church’s obligations as a tax-exempt entity and ensuring clarity in financial reporting with donors and board members.

Set up and maintain internal controls for your church

Without proper checks and balances for your church accounting, your church is left open to fraud, embezzlement, and improper financial management. Such mismanagement decreases trust among church members, your church board, and the community in which you serve.

Internal controls are a critical first step in demonstrating transparency, accountability, and financial stewardship within your church’s financial department. Implementing internal controls helps you protect your assets, ensure accurate financial reporting, and promote accountability. Here are my recommendations for your church’s internal controls:

• Segregate accounting duties: One of the fundamental principles of internal controls is to separate financial responsibilities among different individuals. For example, the person who approves expenditures should not be the same person who writes the checks or reconciles the bank statements. This reduces the risk of errors or fraud and ensures that no single individual has too much control over financial transactions.
• Establish financial policies and processes: Clearly defined financial policies and procedures provide a framework for how financial activities are conducted within the church. This should include guidelines for handling donations, managing expenses, processing payroll, financial reporting, and other church accounting tasks. These policies should be documented and regularly reviewed to ensure they align with best practices and regulatory requirements.
• Set up approval workflows for transactions: For example, you can require church board approval for expenses over a set amount and insist on having two signers on checks. Also, use a purchase order system for major expenditures.
• Maintain good recordkeeping: It’s important to maintain thorough documentation for all financial transactions, including receipts, invoices, and records of donations. This creates a historical record of your church’s accounting and proves invaluable when audits occur or when accounting discrepancies come up. 
• Establish a routine schedule for financial reporting: Be sure to relay details on income, expenses, and cash flow to the church board or finance committee in a way that’s timely, clear, and practical.
• Perform regular accounting reviews: Many churches neglect periodic reviews of their accounting processes and statements, leaving themselves open to fraud and the possibility that overlooked small financial errors will turn into a big mess. The IRS can only begin a church tax inquiry if there is “reasonable belief” that it does not meet tax-exemption requirements or that it is not paying tax on unrelated business income. However, I recommend you perform an “audit readiness” assessment regularly so you can keep your accounting compliant and avoid unpleasant surprises from financial errors later.

Manage designated and restricted funds well using fund accounting

Set up proper fund accounting processes and policies to ensure you abide by donation guidelines and preserve financial transparency and goodwill with donors. Good fund accounting will ensure you properly account for restricted funds (like endowments) and unrestricted funds.

For example, if you believe you may need to repurpose a donor’s gift, there are two ways to gain donor permission to do so:

1. Include a disclaimer in your solicitation and donation receipts that states your organization reserves the right to use money as it sees fit.
2. If you have already received designated funds and now need to repurpose them, you can ask donors directly in a membership meeting or in writing for their permission to repurpose their gift. 

Of course, this brings up the question of whether donors can legally enforce their gift’s designated purpose if your church decides to abandon the designated fund’s project or reallocate designated funds.  

This topic is worth an article of its own, but the short answer is that most legal precedence states that because a gift involves the transfer of ownership and control from the donor to the donee (church), the donor has no legal control to enforce how their donation is used. However, this can vary by state and you should always check with a church law attorney who can advise you on legal complexities like this.

Manage payroll taxes well for church staff and clergy

Unlike standard businesses, churches face unique challenges and responsibilities when it comes to payroll, as they must navigate both federal tax laws and special considerations for clergy compensation. Properly handling payroll taxes not only ensures compliance with the IRS but also safeguards the church from potential financial penalties.

Here are some specific ways in which your church can properly manage payroll taxes:

• Excluding ministerial housing allowance from gross income for tax purposes instead of including it as washes on Form W-2.
• Classifying clergy staff as self-employed workers for payroll and Social Security and Medicare taxes instead of employees. You can learn more about pastoral payroll here.
• Filing quarterly Form 941 payroll tax returns on time.
• Remitting withheld payroll taxes to the IRS accurately and on time.

Be prepared for Unrelated Business Income (UBI) complexities

While churches are typically exempt from federal corporate taxes under Section 501(c)(3) of the federal tax code, they may be subject to taxation on income from unrelated business activities. This can become quite nuanced and present some challenges as you navigate the day-to-day accounting tasks for your church.

To determine whether church income qualifies as unrelated business income, and is consequently subject to tax, you can answer these questions:

1. Was the income derived from a trade or business? The definition of a “trade or business” is broadly defined as “any activity that generates income from the sale of goods or providing of services.” Nearly any income a ministry might collect (other than legitimate donations) may qualify as “trade or business” income, even sales of hot coffee.
2. Is the organization regularly engaged in the trade or business? The IRS considers an activity to be "regularly carried on" if it shows a frequency and continuity similar to a comparable commercial business. This means that occasional or sporadic activities may not be deemed regular and the income may not be subject to UBIT. However, if the activity occurs repeatedly or consistently, it may be considered regularly carried on, making the income taxable.
3. Is the activity unrelated to the organization’s exempt purpose? For income to be classified as unrelated business income, the activity generating the income must not be substantially related to the organization's tax-exempt purpose. For example, if a church operates a bookstore selling religious materials, the income might be considered related and exempt. However, if the same bookstore primarily sells secular items unrelated to the church's mission, the income could be deemed unrelated and subject to tax. The key factor is whether the activity directly supports the organization's exempt purpose.

Maintain audit readiness within your church finances

Demonstrating financial stewardship is more than just a best practice for churches. It is a reflection of their commitment to their mission, their community, and their faith. Taking steps to prepare for an audit ensures that your church’s funds are handled appropriately and bolsters donor confidence by demonstrating responsible stewardship. To stay prepared for an audit, make sure your church bookkeepers do the following:

• Conduct internal reviews of finances.
• Review financial reports with leadership.
• Perform monthly account reconciliations.
• Keep contribution records current and accurate.
• Ensure financial staff understand accounting processes.
• Stay updated on relevant tax laws and financial reporting requirements.

Avoid improper benefits to individuals and board members

When a church engages in activities that personally benefit board members or close relatives, it can cause problems later. First, church board members have a fiduciary requirement to act in the best interests of the church rather than for personal gain, or else they may face legal penalties. Second, according to 501(c)(3) requirements described by the IRS, churches must be exclusively for charitable purposes, so engaging in activities that benefit private individuals can result in the loss of tax-exempt status, as well as other penalties.

To ensure transparency and maintain donor trust, I recommend your church:

• Establish clear policies and procedures for board member compensation and reimbursements, then review and update them regularly.
• Ensure board member compensation is reasonable and in line with industry standards. I recommend obtaining independent third-party assessments to validate compensation amounts.
• Require detailed expense reporting and receipts for any reimbursements to board members. Review these carefully to ensure they are for legitimate church-related expenses.
• Prohibit board members from receiving any special privileges, such as free or discounted services, that are not available to all church members.
• Maintain detailed and transparent financial records that clearly document all payments and benefits to board members.
• Consider having board members sign annual conflict of interest disclosures to identify any potential conflicts.

Excessive lobbying or political involvement

The key for compliance related to political activities is to have clear boundaries, detailed record-keeping, and independent oversight that keeps your church in compliance with laws restricting your church’s political activities. 

Here are some tips to help you keep your churches compliant with regards to improper political activities like lobbying:

• Establish clear policies prohibiting the use of church funds or resources for political campaign activities, lobbying efforts, or other partisan political purposes.
• Ensure all staff and board members are trained on these policies and understand the legal restrictions on churches engaging in political activities.
• Maintain detailed financial records that clearly separate any political or lobbying expenditures from the church's general operating budget and activities.
• Avoid endorsing or opposing specific political candidates from the pulpit or in church communications. Provide nonpartisan voter education resources instead.
• If the church does engage in any permissible lobbying activities, ensure those are properly tracked and reported as required by law.
• Implement strong internal controls and oversight measures to prevent unauthorized political expenditures or activities.

You can review more details about political activities and nonprofits on the IRS website.

Review your state’s regulations to ensure tax-exempt compliance

There are various obligations that must be handled for your church at the state level, in addition to the federal level. For example, nonprofits must generally register with the Secretary of State office and file an informational report (Form 990) with them each year. But there may be specific tax filing requirements and nuances that apply to your state only.

For example, tax-exempt organizations in California must file one or more of the following forms with the Franchise Tax Board (FTB):

• FTB 199N (California e-Postcard)
• Form 199 (Exempt Organization Annual Information Return)
• Form 109 (Exempt Organizations Business Income Tax Return)
• Form 100 (Corporation Franchise or Income Tax Return)

I’d recommend contacting a church CPA who can help you navigate your state’s specific reporting requirements, as well as your federal obligations.

Use church accounting software to manage finances

While you can do much with a set of Excel templates for church accounting, there are many reasons to use church accounting software. For example, with Aplos, you can do the following:

• Designed for fund accounting: Aplos is made to help churches easily track designated funds, integrate with Gusto payroll for easier pastoral payroll and housing allowances, and provide efficient church bookkeeping.
• Powerful custom financial reports: With Aplos, you can build custom financial reports that let you track funds by project, campaign, or ministry so you have detailed budget reports. If needed, you can get even more granular reporting using tags.
• Effective and efficient donation tracking: When you use Aplos, all donations given online are tracked by donor and purpose automatically for both accounting purposes and giving statements.

If you are interested, you can read more about how Aplos can benefit your church’s accounting operations here, and read this helpful comparison of Aplos and QuickBooks from the Aplos team.

Create and follow an annual budget

Church annual budgets are crucial financial tools that guide ministry efforts and ensure responsible stewardship. Here are my recommendations for creating and maintaining your church’s annual budget:

• Review past performance: Analyze the past 3-5 years of income and expenses to identify trends and inform projections.
• Involve key stakeholders: Include input from ministry leaders, finance committee members, and other key stakeholders in the budgeting process.
• Prioritize expenses properly: Categorize expenses based on importance and urgency. Consider using a program-based budgeting approach to evaluate the effectiveness of each ministry area.
• Regularly monitor and adjust your budget: Review the budget monthly or quarterly, comparing actual results to projections. Be prepared to make adjustments as needed throughout the year.
• Communicate transparently about budgetary usage: Share budget information with the congregation and board members regularly and explain how financial resources are being used to further the church's mission.

Hire a church accountant to ensure you have proper guidance and advice

As your church grows, hiring a church accountant ensures that your church maintains proper financial guidance and adheres to tax and accounting compliance. Beyond bookkeeping, a church accountant can navigate complex areas like tax-exempt status, charitable contributions, and payroll management, ensuring that all financial records are accurate, transparent, and up-to-date. 

More resources to ensure proper church accounting and tax compliance

Good church accounting practices are vital to the long-term success of your church and its programs. If you’d like to learn more about getting your financial operations in order, I recommend the following resources:

• Webinar Review of Month-End Closing Procedures
• A Guide to Fund Accounting for Churches
• 10 Powerful Church Growth Strategies