Religious Property Tax Exemptions: A Sticky Issue

Last week an article appeared on Forbes online that caught my attention. The article discussed a Tennessee case in which a megachurch sought (ultimately unsuccessfully) property tax exemption for portions of its real property used for a bookstore and a fitness center. You can read more of the details in the article.

Essentially the church argued that part of its religious worship was operation of these facilities to create a “third space” environment. Many churches are engaging in such activities – bookstores, fitness centers, coffee shops, etc. The question of taxation is often analyzed from a federal income tax standpoint. Are these activities related or unrelated to the church’s exempt purpose? If unrelated, are they substantial? If unrelated are there exceptions to payment of unrelated business income tax (such as being operated for the benefit of members only, being operated by volunteers, etc.)? What is often (and unfortunately so) overlooked is property tax exemption, a very important benefit for churches.

Property Tax_church

Property tax exemption does not track federal tax exemption. It is a different scheme altogether. Each state is responsible for determining how it will tax (or exempt) various institutions. In my home state of Texas, for example, churches are exempt but a 501(c)(3) animal rescue clinic is not. The specific state statute has to be consulted to determine eligibility for property tax exemption. Again, in Texas, for example, among other things churches may seek exemption of real property owned by the church and used as a place of regular religious worship but only as to that portion of the property reasonably necessary for engaging in religious worship. Most observers would agree this includes the church sanctuary. But what else? The choir rehearsal room? The fellowship hall? The church offices? The green space behind the church used for the annual Easter Carnival? These are issues that require interpretation. Likewise, the question of a church bookstore and fitness center require interpretation. The problem arises because the First Amendment makes it a little sticky for a local county official (the tax assessor initially and later the court) to interpret whether these ancillary areas are “reasonably necessary” for engaging in religious worship.

This problem isn’t isolated to property tax issues. In fact, while the Internal Revenue Code recognizes an exemption from federal income tax for religious organizations, neither the Internal Revenue Code nor the Treasury Regulations define the term “religious.” Likewise, the term “church” is found, but not defined, in the Internal Revenue Code. The IRS has tackled the question by looking at a number of factors that it considers indicia of being a church (in Stephen Colbert-speak: evidence of churchiness). Courts have likewise looked to such “indicia.” But in these instances, the IRS and/or the courts are merely trying to determine whether the organization itself – in totality – is a church. The local tax assessor has a much more difficult (constitutionally-speaking) question: are specific areas reasonably necessary for engaging in religious worship which begs the question of whether the activities undertaken in those areas is, in fact, religious worship. That’s sticky.

And so we are left with an ad hoc state by state (if not county by county) analysis of religious property tax exemption. One solution would be to draw a bright line: no exemption at all or exemption only for the primary sanctuary. An alternative would be to base property tax exemption on whether the property is used for a related purpose utilizing the body of law that has developed under Section 513 of the Internal Revenue Code with respect to unrelated business income. Either would be better than spending the nonprofit’s money and the government’s money on legal fees and court costs.

Until then, though, don’t neglect concern for property tax exemption and consult a local lawyer who can tell you the “lay of the land” in your specific county.

What is a nonprofit organization?

1070609_65995437Because my practice focuses on nonprofit and tax exempt entities, when clients call me to seek help in starting a new organization typically they’ve already made the decision to take the nonprofit form. However, the decision as to whether to take the nonprofit form as opposed to the for-profit form is a critical first choice. And that choice can’t be made without first understanding just what is a nonprofit? Stated another way, what makes a nonprofit unique?

Many people consider nonprofit as synonymous with tax exempt or even charitable. Neither is the case though tax exempt and charitable organizations do take the nonprofit form. The vast majority of nonprofits are tax exempt and recognized as charitable organizations described under Section 501(c)(3) of the Internal Revenue Code; however, there are many others that do not fit that classification. Organizations are not charitable such as social welfare organizations, business leagues, professional associations, labor unions, political organizations, and title holding companies to name a few are tax exempt but not charitable. There are also nonprofits that are not tax exempt at all. For example, in Texas, statutory law prohibits the corporate practice of medicine. An exception is a practice in the form of a nonprofit known as an accountable care organization. Such an organization takes the nonprofit form for corporate state law purposes but is not required to be tax exempt (though under certain circumstances it can be!).

Many mistakenly believe the core characteristic of nonprofit organizations is a prohibition from either making or retaining profits, in other words, their revenues must be less than their expenses. This is incorrect and would cause most nonprofits to Close their doors. However, it does have a tinge of accuracy. Profits do lie at the center of nonprofits though the prohibition is not on the organization making or retaining a profit but on profits at the ownership/control level.

At its core a nonprofit is unique because of something referred to as the non-distribution constraint — that is, absent of paying reasonable compensation, nonprofits are prohibited form passing on profits to their owners/controlling parties. In most states, nonprofits do not have owners at all but are rather controlled by a governing board typically referred to as its board of directors.

Understanding the inability to pass profits on to owners other than as reasonable compensation, what are some of the factors to consider in making the decision whether to take the nonprofit form? Most often the decision is made because the organizational founders desire to seek tax exempt status. Nevertheless, care should be taken to understand that, as referenced above, nonprofit form does not equal tax exempt status. To qualify for exempt treatment under the Internal Revenue Code (as well as for state law purposes), an organization but be organized and operated for exempt purposes.

For organizations that can demonstrate they are organized and operated for exempt purposes, the founders must consider whether they are satisfied leaving profits at the organizational level and receiving only reasonable compensation. Founders that desire to grow a business and reap the profits either through dividends, bonuses, or upon sale, the nonprofit form would be inappropriate.

A second reason for choosing the nonprofit form is licensing or statutory requirement. The accountable care organization referenced above is an example.

Some founders will choose to take the nonprofit form for the perceived “halo effect.” That is, some view nonprofits as more trustworthy and founders seek to tap into this trust. This could apply in the context of a hospital, daycare or camp. Each could take the for-profit or nonprofit form.

Other factors that could play into the decision (though much more ancillary) are nonprofit postage rates, the number of governing persons (in Texas there must be three members of the board of a nonprofit corporation and must be at least three people involved to form a nonprofit unincorporated association), opportunity for certain types of government assistance, and liability protection under certain circumstances.

Once the decision has been made to take the nonprofit form, the decision moves to what form is the appropriate form. And that will be the topic of the next post.