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.

Nonprofit Formation: Choosing the Vehicle

164177997Once the decision has been made to operate in the nonprofit form, the next decision is the proper organizational vehicle. For nonprofit organizations that will ultimately seek tax-exempt status as organizations described under Section 501(c)(3) of the Internal Revenue Code, the options are charitable trust, unincorporated association, nonprofit corporation, and limited liability company. The choice of vehicle largely depends upon the aims of the organizers and anticipated operations of the organization. It is also largely a decision based upon state law concerns (with a few exceptions). This blog post will discuss the decision in the context of Texas law.

Charitable trusts are the oldest form of nonprofit“entity,” tracing their roots back to the Statute of Charitable Uses of 1601. At its simplest, a charitable trust is a fiduciary relationship with respect to property whereby property is held in trust for charitable purposes. Texas law defines a charitable trust as “a charitable entity, a trust the stated purpose of which is to benefit a charitable entity, or an inter vivos or testamentary gift to a charitable entity.” Tex. Prop. Code§123.001(2). A charitable trust is created by a settlor irrevocably transferring property to a person or entity as trustee with the intention of creating a charitable trust. This creates the fiduciary relationship though it is often referred to as an entity.

Aside from the benefit of having many years of established case law, many organizers choose charitable trusts as the organizational form of their entity because of the rigidity of the vehicle. A settlor is able to establish the trust with specific purposes and be assured that the trust will operate for those purposes absent court intervention. The settlor also has the security of knowing the trustee(s) will be held to higher fiduciary standards (though the same fiduciary duties) in performing his or her duties than directors of nonprofit corporations. While the rigidity of trusts can be viewed as a benefit, that same feature may be viewed as inflexibility and thus may be viewed as a detriment to others looking to choose an entity. The ability to modify a trust requires court intervention and is not automatic. In Texas, trustees are more limited as to their investments as well as their ability to delegate duties. Trustees are additionally subject to more stringent conflict of interest and self-dealing prohibitions and must meet a higher standard for indemnification as compared to directors of unincorporated associations or nonprofit corporations.

Nonprofit unincorporated associations are the default nonprofit organization in Texas. Texas defines a nonprofit unincorporated association as an unincorporated organization, other than one created by a trust, consisting of three or more members joined by mutual consent for a common, nonprofit purpose. See Tex. Bus. Orgs. Code Ann. § 252.001 et seq. Formation of an unincorporated association is not governed by statute and does not require any organizational documents although an unincorporated association will typically have articles of association, a constitution, or bylaws (and will be required to have such documents to seek tax exemption).

The existence of an unincorporated association in Texas is governed by Chapter 252 of the Texas Business Organizations Code (“BOC”). That chapter clarifies that an unincorporated association is a separate legal entity from its members with powers to promote the aims and purposes of the organization and advance the members interests by all legitimate and legal means. Unincorporated associations have the right to sue or be sued, sue or be sued by a member, acquire, hold, encumber, transfer real or personal property without the need for trustees, be a beneficiary of a trust, contract, will, or policy of life insurance, apply for property tax exemption, and apply for federal tax exemption under Section 501(c)(3) or another section.

Benefits of operating as an unincorporated association relate primarily to the informal nature of such an entity. Unincorporated associations are relatively quick and easy to establish and are internally as flexible as the founder’s desire. Finally, unincorporated associations have the ability to rely on statutory authority in Texas to assure that they are recognized as separate legal entities such that members do not have personal liability in tort or contract absent special circumstances.

On the contrary, there are numerous drawbacks to organizing as an unincorporated association. First and foremost, while Texas has adopted Chapter 252 of the BOC (which was derived from the Uniform Unincorporated Nonprofit Association Act, only in place since 1995), there is little case law interpreting either Chapter 252 or its predecessor act, leaving an element of the unknown. Second, because unincorporated associations are so flexible, a founder has less assurance that his or her wishes as to the direction and purposes of the organization will remain unchanged. Many unincorporated associations find they have trouble with potential lenders who are more comfortable dealing with corporations than with unincorporated associations. Finally, choice of law concerns exist where an unincorporated association acts outside Texas as not all states recognize such an entity. Practically speaking, for an unincorporated association to qualify for federal tax exemption under Section 501(c)(3) the unincorporated association must make itself look and act quite a bit like a nonprofit corporation through adoption of a governing instrument with the requisite provisions for exemption thereby lessening the benefits discussed above.

Perhaps the most commonly used entity for exemption under Section 501(c) is a nonprofit corporation. Nonprofit corporations in Texas are governed by Chapter 22 of the BOC. The BOC defines a nonprofit corporation as a corporation no part of the income of which is distributable to a member, director or officer of the corporation. It is helpful to note here that income may be distributed to individuals performing services on behalf of the corporation in the form of salary as long as those salaries are reasonable and commensurate with the services rendered. Nonprofit corporations in Texas may be organized for any lawful purpose, but keep in mind that to qualify for recognition of exemption the corporation must be organized with an appropriate purpose identified (e.g. religious, charitable, educational, etc. for Section 501(c)(3) organizations). Pursuant to Chapters 2 and 22 of the BOC, nonprofit corporations have the ability to perpetually exist, to sue and be sued in their corporate name, purchase, lease, or own property in the corporate name, lend money (so long as the loan is not made to a director), contract, make donations for the public welfare, and exercise other powers consistent with their purposes. While having extensive powers, nonprofit corporations remain internally flexible with the power to amend their operations and purposes through board (or member) action. Whereas unincorporated associations lack extensive statutory guidelines and case law guidance, nonprofit corporations in Texas have Chapter 22 and its predecessor, the Texas Non-Profit Corporation Act, with extensive case law interpreting it, as well as the ability to analogize to for profit corporate law.

There are few drawbacks to organizing as a nonprofit corporation, particularly when the organization will be seeking federal tax exemption under Section 501(c)(3). While establishing and maintaining a nonprofit corporation does require more work (and therefore more expense) as compared to an unincorporated association, the same work will have to be done for an unincorporated association in the event that it is seeking federal tax exemption. Furthermore, while a nonprofit corporation is subject to the Texas franchise tax, certain federal exemptions (including under Sections 501(c)(3) and 501(c)(4)) qualify the organization for exemption from the franchise tax as well. Finally, many of the various rules that are required for nonprofit corporations applying for exemption (such as specific dissolution clauses and the like under Section 501(c)(3)) are a requirement for any organization seeking exemption. Absent specific circumstances such as an organizer wishing to set up a Section 501(c)(3) entity as a charitable trust to take advantage of the specific characteristics and benefits of such an entity, it is generally most beneficial to organize as a nonprofit corporation.

The final entity eligible for exemption for under Section 501(c) is a limited liability company (“LLC”). LLCs are unique in their eligibility for exemption. Unlike the other forms discussed above, the LLC is used as a single-member entity with an exempt organization as the single member or alternatively as a multi-member LLC with all of the members being exempt. LLCs are governed by the Business Organizations Code and specifically Chapter 101. LLCs can be member-managed or manager-managed. In the exempt organization context, this means the member (the exempt organization) can manage the LLC by acting though its own board of directors or can appoint others to manage the LLC with those “others” acting essentially as a board of directors of the subsidiary LLC.

Chapter 101 of the BOC provides that members and managers are shielded from debts, obligations, and liabilities of the LLC. This liability protection, with the simple control (such as management overlap) is a beneficial feature of the LLC being used as a subsidiary-type organization, particularly in holding and operating assets that have the potential to be high-risk assets or activities. Furthermore, where the LLC is a single-member LLC with the single member being an exempt organization, federal tax law provides that the LLC will be disregarded meaning that the LLC does not need to separately apply for tax-exempt status (discussed below), but rather will effectively take on the tax attributes of its parent member. On the flip side, if the LLC has not separately applied for exemption, while it will not be taxable for federal income tax purposes, it will remain taxable for Texas franchise tax purposes unless it can qualify for exemption. In other words, because the LLC has itself not obtained 501(c)(3) or 501(c)(4) status, it cannot use such status as its basis for exemption from the Texas franchise tax. This same concern applies with respect to the Texas sales tax. Finally, Texas property tax rules do not provide for any property tax exemption for LLCs—a significant drawback for any LLC that would hold real property that could be exempt on the basis of the type of organization.

Should a single member LLC wish to apply for exemption (as opposed to being disregarded entity) or should the LLC have multiple members, separate conditions apply. The IRS has indicated that it will recognize the 501(c)(3) exemption of an LLC if the LLC otherwise meets the qualification for exemption (which will be discussed below) and meets certain additional conditions in its organizational documents.

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.