Incorporation and Tax Exemption
By Richard R. Hammar, J.D., LL.M., CPA
© Copyright 1991, 1998 by Church Law & Tax Report. All rights reserved. This publication is designed to provide accurate and authoritative information in regard to the subject matter covered. It is provided with the understanding that the publisher is not engaged in rendering legal, accounting, or other professional service. If legal advice or other expert assistance is required, the services of a competent professional person should be sought. Church Law & Tax Report, PO Box 1098, Matthews, NC 28106. Reference Code: m65
Should a private religious school incorporate? Should it seek exemption from federal income taxes? These are questions of fundamental importance for private religious schools. The answers depend primarily upon the relationship if any that a particular school has with a church. As a general rule, it would be advantageous for a religious school operating independently of any control or supervision by a church to be incorporated.1 Such a school also should apply for recognition of tax--exempt status. This procedure is discussed in Federal Income Taxation.
Most private schools are connected with a particular church congregation and are subject to the direct supervision and control of the church. Most courts have held that such a school constitutes an integral part of the church and therefore shares the church's corporate status as does any other department or ministry of the church. To illustrate, one court has observed that “a school may be considered as an integral and inseparable part of a church” even though not every church has a full--time school associated with it.2 Accordingly, the court held that a church school was a proper use of property zoned for church uses. Other courts have concluded that a private religious school controlled by a church is an integral part of the parent church and hence shares the church's exemption from state unemployment taxes.3 A federal judge has observed that a private religious school is a “direct, intimate adjunct of church activities conducted in the house of worship. From the earliest days, when governments were doing absolutely nothing about it, nearly all religious denominations have conducted school, including colleges, as an integral part of their activities.”4
Since under the prevailing view a church--operated school is considered to be an integral part of the church, the school will share the church's corporate status and need not be separately incorporated. It will derivatively enjoy all the advantages of the corporation form of organization because of its relationship with the church. Of course, this discussion assumes that the church itself is incorporated and exercises sufficient control over the school to support the conclusion that the school is in fact an integral part of the church. If the church with which a school is connected is not incorporated, the proper procedure would be to incorporate the church and not the school.
Some churches have separately incorporated their schools to insulate themselves from legal liability that might arise from such operations. This tactic will fail in most cases if a church continues to exert control over the new “corporation,” since the misconduct of a wholly owned subsidiary corporation generally is attributable to the parent corporation if the latter exercises sufficient control over the subsidiary. If the directors, administration, and staff of a separately incorporated church school are selected by or subject to the approval of the parent church, and if title to the school property is in the name of the church, the fact that the school is a separate corporation may not insulate the church from liability for injuries or damages that occur in the course of school operations.
Separate incorporation of a church--operated school also will suggest that the school is not in fact an integral part of the church. This obviously could have adverse consequences since the school's tax--exempt status typically derives from its integral relationship with its parent church. It also might prevent the school from being operated on land zoned for church use.
In most cases a church--operated school will share the parent church's exemption from federal and state income taxes, local property taxes, and unemployment taxes. This conclusion assumes that the school is controlled by a church to such a degree that it can be said to be an integral part of the church. If a church--operated school is separately incorporated, it may not be deemed to be an integral part of the church and thus its exemption from various federal, state, and local taxes may be jeopardized. To illustrate, the United States Supreme Court, in ruling that church--operated schools share a parent church's exemption from unemployment taxes, specifically limited its ruling to unincorporated church--operated schools having “no separate legal existence from a church.”5 The Court concluded that the section of the federal unemployment tax law exempting service performed in the employ of a church was meant to apply to unincorporated church--operated schools. However, the Court acknowledged that the law exempted incorporated church schools that were “operated primarily for religious purposes and that were operated, supervised, controlled, or principally supported by a church or convention or association of churches.”6
The income tax regulations specify that a separately incorporated church school is not entitled to tax exemption as an “integrated auxiliary” of a church.7 The implication of this regulation is that unincorporated church--operated schools share the tax--exempt status of their parent church, that separately incorporated schools do not, and that separately incorporated schools are not eligible for exemption as “integrated auxiliaries” of tax--exempt churches.
In summary, it would appear to be the view of the IRS that a separately incorporated church school must independently apply for and obtain tax--exempt status. It could be argued, however, that in some cases an incorporated church school is entitled to tax--exempt status. For example, “integral parts” of churches, as defined in the income tax regulations, are exempted from the federal tax on unrelated business income whether or not they are incorporated. There is no reason why such entities should also not share a parent church's exemption from other federal taxes.8
The Church Audit Procedures Act, adopted by Congress in 1984, significantly limits IRS audits of churches and some unincorporated church--controlled activities. The Act does not apply to separately incorporated church schools.9
For related information on this topic see the following articles:Proof of Nondiscrimination in Private Schools
Right to Attend Private Schools
The Distinction Between Public and Private Education
Discharge and Discipline of Students of Private Schools
Discharge and Discipline of Teachers
Application of Federal Labor and Discrimination Laws to Private Schools
Government Regulation of Private Schools
Zoning Laws and Private Schools
Safety and Health Regulations for Private Schools
Taxation of Private Religious Schools
Child Abuse Reporting Requirements for Private Schools
Legal Liability for Student Injuries