Answer: You are compensating workers for their services, not donating to volunteers. Being a charity or a church does not excuse your converting taxable compensation to a tax-free donation.

Your workers receive income on which they owe income taxes. If these workers are independent contractors, you are required to report annual payments totaling $600 or more on Form 1099.

If, however, these workers are actually employees — you have the right to control how they perform their services — then payments are reported on Form W-2, and you are responsible for tax withholdings and payroll taxes.

A charity’s directors and officers can be held personally liable if the charity fails to withhold taxes on employees. Because a charity is required to make distributions to proper charitable beneficiaries, the charity could, in an extreme case, lose its tax-exempt status entirely for making these "donations" to its workers, since they are not beneficiaries.

Further, if the amount paid is excessive compared to the fair market value for services received, you have another problem; see the next question.

Question: We’re a tax-exempt charity and a nonprofit public-benefit corporation under California law. How much can we pay our workers?

Answer: Compensation for services may not exceed the fair market value ("FMV"). This rule covers not only compensation for employees and independent contractors, but also transactions of goods or real estate. Payments in excess of FMV waste charitable assets, and the State’s Attorney General may hold a charity’s directors personally liable, unless the money is recovered.

Widespread and persistently excessive compensation confers a private benefit to employees and consultants, violating a charity’s tax-exempt status, and may cause IRS to revoke your charity’s exemption.

Be careful, too, in the relationships that volunteers may have: When an employee or consultant has substantial influence over the charity, there could be a private inurement (an improper personal benefit).

In addition to the charity losing its tax exemption, the directors approving a private inurement may be personally liable for breach of their fiduciary duty to protect the charity’s assets. Also, IRS may levy punitive taxes on the employee or consultant, as well as the managers who approved such transactions.

Remember, if the employee or consultant is a director, the Board should follow state corporate law requirements in approving compensation, regardless of whether it is excessive.

Question: We are a church, with two full-time pastors, each of whom receives $50,000 a year salary. One lives in the parsonage at our church; the other receives a $25,000-per-year housing allowance. How are these housing arrangements taxed?

Answer: Under federal law neither the housing allowance, nor the rental value of the housing provided, are included in the pastors’ gross income. However, each must be a bona fide "minister of the gospel." The pastor receiving the housing allowance must spend all of it on housing. Any unused portion is considered salary and taxed at ordinary income rates.

Note: A minister who owns a personal residence and also receives a tax-exempt rental allowance is still permitted to deduct mortgage interest and property taxes on his home.

Note: California follows federal law, although it denied a housing exclusion to a minister who taught biblical studies at a university, ruling that the university was not operated as an integral part of a church.