In Part one of this series, we examined the basics of the Church Audit Procedures Act.  In this Part, we are taking a look at what measures a church can take to be prepared in the event of an IRS examination.  These steps are not just to ward off the IRS, but are just good, basic business practices.

First, understand that there is not a high risk of your church being the subject of an IRS examination.  Although the IRS does not disclose such data, it is estimated that fewer than 100 churches per year are examined.  Those subject to such audits are those examining the most conspicuously bad behavior.  There is a higher chance that the Department of Labor would examine a church for violation of the Fair Labor Standards Act, but that is a topic for another time.

In order to protect the church there are several procedures that the church should implement.  One of the easiest aspects to overlook is a review of the church activities.  Does every activity undertaken by the church bear a relationship to its mission?  If the activity cannot be shown to be related to the mission of the church, consider eliminating that activity.

Keep good records.  This includes legal, financial, donor, and personnel records maintained by the church, readily accessible, but not open to everyone.  Electronic storage is permissible.  The church should have a records retention policy and FOLLOW THAT POLICY.

Properly classify employees as employees and independent contractors as independent contractors.  This is an IRS hot button.  If an employee has been treated as an independent contractor and the IRS rules the person is an employee, the church will be liable for both halves of social security and Medicare taxes.  In the same vein, document the status of ministers.  This should include a copy of the minister’s ordination, licensing, or commissioning document in his or her personnel file.  Also, there should be a position description in the file for each minister.

Stay current on employment tax filings.  Failure to timely file Form 941 or related forms and not making timely tax deposits is a sure way to attract unwanted attention of the IRS.  In addition, be up to date on the proper filings of Forms W-2, 1099-MISC, and other forms that may be required.

Be certain your church is not liable for any unrelated business income filings.  Having more than $1,000 in gross unrelated business income could subject the church to an income tax liability on that income.  Failure to file and pay the tax could result in penalties and interest, which can be significant.

Properly handle employee expenses, reimbursements, and allowances.  Particular attention should paid to any spousal travel expenses.  Document the personal use of any church owned or leased vehicles.

Maintain appropriate giving records for cash and non-cash contributions received by the church.  Be aware that the church should provide the donor with contribution statements that include the fair market value of anything of more than token value received in return for the contribution.  If a motor vehicle, boat, or airplane is donated to the church, be certain to provide the donor with a properly completed Form 1098-C and file the form with the IRS within 30 days of the contribution.

Finally, if your church is operating properly, you likely have nothing to fear.  But it is best not to go it alone.  If the IRS wants to examine your records, secure the assistance of a competent tax return preparer – a CPA or enrolled agent who is familiar with church tax issues.  You don’t want to go into the “mouth of the lion” without proper preparation.