Be Careful with “Catchup” Payments to Previously Undercompensated Employees

Many churches have had their pastors and other employees take less than their approved salaries over the years in order to help the church through tough economic times. When the church is better off financially, the church begins to play “catchup” and pay some of the previously under received salaries to the pastor or other employees.  This practice is not just with churches but also with ‘for profit’ businesses.

The basic rules indicate that compensation for prior years’ services (“catchup payments”) can be deductible in the current year as long as the employee was actually under-compensated in prior years and the current payments are intended as compensation for past services.  When compensation was actually for prior years service, it need not be reasonable in the year it was paid.

Recently, the Tax Court in Thousand Oaks Residential Care Home I, Inc., et al, TC Memo 2013-10 found that a portion of the amounts paid from a corporation to its owner and his wife, both in the form of salary and pension plan contributions, was unreasonable.  The owner and his wife from 1973-1983 received no salary from the corporation.  From 2003-2005 the corporation paid ‘catchup’ funds for the owner of $880,939 and to his wife of $820,348.  The corporate minutes explained that these amounts were payments of back salaries that weren’t paid in prior years due to insufficient cash flow.

The court found that the amount of compensation during the years of non-payment of salary was substantially higher than the Bureau of Labor statistics, even when accounting for the earlier years’ under compensation.  The years of under compensation  did not have established salaries at the time, the salaries for ‘catchup’ purposes were established at the time that they were to be paid at the later date.  The court also found that the $880,939 and the $820,348 amounts effectively depleted the corporation’s assets as the payments were made when the corporation assets were sold..

The lesson from this case for the church is that (1) salaries should be established for each year even if the church knows that it may not be able to pay that amount.  In that way the reasonableness of the compensation is made at the time compensation would be due and therefore, whatever shortage occurs would be calculated against the reasonable compensation. (ie. reasonable salary determined to be $40,000 but church only paid $25,000, amount still owed would be $15,000)  (2) These amounts would be better paid when church finances allow rather than when the pastor or employee is leaving the church so the depletion of corporate assets would not enter into the consideration of the overall reasonableness of the compensation paid at that time.

If handled properly, the ‘catchup payments’ made to the pastor or other employees will allow then to received their full salaries for under compensated years and will not cause red flags or any concern by the Service.  Prepare to handle these matters properly for the benefit of both the pastor or employee and the church.

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