Risk Management Library

By Robert Erven Brown, Esq.

(This article first appeared in Church Business on April 1, 2003.)

Does your congregation hold legal title to its campus in a corporation that regularly engages in high-risk activities? These include hiring the pastors and staff, operating a school and conducting off-campus travel for school children, church members and guests.

If so, it’s time to conduct a detailed review to determine two things: whether the fee title to your campus maximizes the probability of preserving the grounds for future generations, and if your legal and accounting practices are sound. If not, then the manner in which the corporations are presently being used neither protects your assets nor promotes sound management.

When should you use two corporations? Is there growing equity in your campus’s value? Is the cash flowing through your church significant enough to be attractive to a judgment creditor? (This does not mean that your church is necessarily creating revenues in excess of expenses. Rather, consider if the cash flow is exposed to a risk that a judgment creditor might force revenues to be redirected to pay a judgment instead of being applied to church work.)

Review your corporate structure. Using one company to hold assets and operate the church creates unnecessary risk. Doing so places all sources of income in one basket. To make matters worse, this is the same basket (company) that also conducts a significant number of risk activities. This form of ownership exposes the equity in the campus to loss in the event of an underinsured or uninsured claim against the church.

The use of multiple legal entities (i.e., corporations or limited liability companies) to isolate risk and to protect assets is a common operating practice among major corporations. This strategy for reducing risk to large holdings has been approved by numerous courts, including the Arizona Court of Appeals in a 1999 case involving the Catholic Church, Taeger v. Catholic Family and Community Services ((196 Ariz. 285, 995 P.2d 721) (1999 Ariz. App.)) Note: These entities might either be limited liability companies or corporations. For ease of reference, we will refer to them interchangeably as “companies.”

This strategy comprises two basic elements for containing and reducing losses arising from risk activities:

1. Isolate the activity. Place the people and risk activities in a separate company, separately fund it, and let it operate under a separate board of directors so that any losses originating from that activity will be limited to the insurance coverage and, in the worst case, to the assets owned by that company.

If properly structured and consistently operated in observance with corporate formalities, usually neither a sister nor parent company will be held liable for the debts of the company that conducts the risk activity. This result is entirely consistent with the original rationale for establishing corporations–to encourage entrepreneurs to enter into risky ventures without having to put their entire personal fortunes at risk.

2. Isolate the assets. By holding fee, or ultimate, title to land or other valuable assets with significant equity (such as patents, copyrights, royalties and endowments) in a company that is legally separate from the primary operating companies and does not itself conduct risk activities, the risk of loss of these valuable assets is significantly reduced if certain legal principles are followed.

There are no guarantees

The use of multiple companies is not an absolute guarantee of protection that your campus will always be used for worship. The courts have reserved the right to review the facts of each situation on its own merit. There is some chance that the corporate veil could be pierced to allow a creditor access to the assets of a sister or parent company. For example, in the case of fraud or open disregard of the separateness of the companies, a court could lodge a judgment against a sister or parent company.

Or, if a large claim exceeds the coverage afforded by a church’s liability insurance, a similar result might occur. If so, then the claimant could seek to force the church to sell these assets to pay the uninsured portion of the claim.

Appropriate insurance, adequate capitalization and a multiple-company structure will give trustees a strong set of legal tools to use in defending (and/or settling) an unjust claim.

Recommendations

As part of the prudent stewardship of church assets, a handful of recommendations can assist your church board in its efforts to follow sound Biblical teachings and to scrupulously observe all federal, state and local tax laws while doing what it reasonably can to:

• Maximize its ability to resist an unjust claim;
• Grant the discretion to have the resources to pay a just claim;
• Avoid creating an unwieldy corporate structure; and
• Maintain conformity to church doctrine.

Consider establishing and operating companies in a manner that matches the day-to-day activities of each company with the assets it holds. Be sure that the legal structure of these companies matches the management and cash flow procedure presently in use by church management. This maximizes the probability that the day-to-day operations follow the legal requirements for protection of assets under the corporate shield doctrine. In this example, we’ll use four separate companies. (We’ll refer to them as corporations, but depending on local law, these could also be limited liability companies, or LLCs.)

Company 1 — The church. Operating as a separate corporation, the church will continue as the major operating company that interfaces with the public through:

• Evangelism and worship;
• Counseling;
• Hospitality and special events;
• Missions and all off-campus travel arrangements; and
• Singles and youth activities.

• Own all buildings and land;
• Receive, hold and distribute endowments;
• Conduct capital and other major fund-raising campaigns;
• Have minimal contact with the public;
• Conduct no-risk activities; and
• Have minimal employees.

This company will receive fee title to the campus from the existing owner, subject to significant use restrictions listed on the deed that transfers title. It will then lease the use of land and buildings to the other companies. Land and buildings used by the church are leased to the church for ministry use.

When two companies share the use of a building, either a shared-use agreement or a sublease is signed between them, just as would be the case in a normal commercial setting, to define the cost and use-sharing arrangements.

If a school is to be part of the church’s mission, consider adding a separate company for that purpose.

Company 3 — Educational company. This company will own and operate the following risk activities:

• Early childhood education
• K-12 school
• Performing-arts education

Company 4 — For-profit company.

This company will conduct all for-profit and miscellaneous activities. This for-profit company will own and operate all for-profit activities and will pay appropriate property and income taxes. The net operating profits will be paid in the form of dividends to its shareholder, preferably the legacy company, which would then provide charitable gifts to the Church or to its sister companies. (The details of the legacy–land-holding–company will own the stock of the for-profit company. Another suggestion is that stock ownership be shared by the Church and the education company. The after-tax profits are then passed, tax-free, in the form of dividends to the Church and to the school. They will pay rent to the legacy company, which could pay the mortgage and provide maintenance services.)

The for-profit activities might include:

• The Bookstore;
• Hospitality and events;
• Memorial services;
• Youth and family recreation;
• Media; and/or
• Any other businesses that compete with other for-profit businesses.

Implementing the Realignment

Step 1: Prepare a concept memo.

Describe the necessary steps to provide a corporate structure that generally mirrors the present management chart but adds one company to hold long-term equity assets in a company that does not conduct significant risk activities.

Prior to implementation, this memo will be discussed, reviewed and approved by tax and audit advisers, legal counsel, insurance advisers, church staff and pastors, all pertinent lenders and, finally, the board and congregation.

The concept memo also will contain an executive summary of these legal tools:

• Leases;
• Subleases;
• Shared-use agreements;
• Deed Restrictions; and
• Inter-company service agreements.

The non-land-owning companies will gain the right to be present on the campus by signing a shared-usage agreement, a sublease or a lease. Each of the usage agreements (or lease agreements) will contain use restrictions limiting the use of the buildings as guided by the Scriptures and as defined in the Articles of Incorporation of the Church.

Staff and other resources may be shared, but each company must pay for the services it uses through inter-company service agreements.

The entity holding title to assets should not have employees.

The operating companies (i.e., the church, the education company and so on) would still own personal property assets: tables, computers, Bibles, chairs, etc.

Step 2:  Obtain approvals in concept and prepare an implementation plan. 

After the tax, accounting, legal and insurance advisers have approved the concept in principle, the pastors and staff must agree on an economical and workable written plan for implementation of the placement of various activities in the legally appropriate companies, giving serious consideration to maintaining year to year consistency in budgeting, staffing and observance of the corporate formalities of:

• Annual meetings and minutes;
• Separate checking accounts and budgets;
• Different-colored stationery and logos for each company;
• Separate boards of directors and officers; and
• Following designated procedures for selecting board members.

Step 3:  Form the companies (or use existing companies) and place assets and activities in them.

Step 4:  Schedule periodic review (annual audits) and annual board meetings to ensure compliance with corporate formalities.  

• Include insurance and legal advisers at least every other year.
• Annual financial audit is recommended.

The main point of the realignment is to isolate long-term equity assets. The details of whether missions activity is in the education company, for example, or in the church are not crucial, provided:

• There is a rational basis for the structure of the companies;
• The overall structure can be consistently followed;
• The structure follows sound tax and accounting principles; and
• The structure can be credibly presented to a reviewing court.

Estimated Costs

Steps 1 and 2:  Memo and analysis phase

The memo stage cost is difficult to estimate since it is unknown how many meetings, revisions, objections, etc., will be encountered. There is an educational process with any lender who has mortgage on your church campus; their consent will be required prior to implementing this program. If only one company and only one lease are used, then the costs will be reduced. If a more comprehensive process is used with subsidiary corporations, then the costs, complexity and the amount of protection are greater. I would be surprised if the legal fees in this phase were more than $5,000 for a small church, but they could be higher for a large church with significant assets. Contact your CPA for an estimate of the costs for tax review and audit review costs.

Step 3: ImplementationThe cost of forming either a corporation or a limited liability company is approximately $750 in Arizona. The implementation stage is actually the least expensive since forming the new entities, preparing deeds, updating title insurance and preparing the usage agreement (or lease) are discrete tasks. This phase would run in the $5,000 to $8,000 range, depending on how much detail is handled in the memorandum stage.

Be sure to plan for annual meetings and preparation of annual minutes, which can be dovetailed with annual congregational meetings. Include a budget item for annual review of books by an independent certified public accountant.

Will using multiple corporations provide real protection to church assets?  The guiding principles behind the use of separate companies are:

• Each company should be legally liable only for those activities which it conducts (then only to the extent of its resources);
• Place risk activities (transportation, hiring and employee matters, child abuse claims, etc.) in an operating corporation;
• Place title to important assets such as the church campus in a holding company that does not conduct risk activities.

These principles permit the church to contain losses within an individual company and to isolate risk activities in a single company (or among several companies) without exposing all of the assets of the church to the risk activities.

The Arizona Court of Appeals specifically noted in a leading Arizona case on this subject that:

It must be noted that a legitimate purpose of incorporation is to avoid personal liability and if the corporate fiction is too easily ignored and personal liability imposed, then incorporation is discouraged. Stock ownership by a few persons does not necessarily mean that corporation debts should be imposed upon them.  For the proposed multi-company structure to provide an effective legal defense to an unjust claim, it is important that both the structure and the operation of the companies meet standard legal tests. In Arizona, the courts have routinely stated that they will allow a claimant to pierce a corporate veil (i.e., allow a creditor to look past the corporate shell and obtain the assets of other brother, sister or parent corporations) only if:

• There is a unity of control to such an extent that the subsidiary corporation is merely a conduit or an alter ego for the activity of the parent.
• In addition, the claimant attempting to piece the corporate veil must prove that honoring the corporations as separate legal entities would sanction a fraud or promote injustice.

In answering this question, we are blessed with specific direction in Arizona from the Arizona Court of Appeals in the 1999 case of Taeger v. Catholic Family and Community Services . In this case, the Court honored the separate legal existence of Catholic Family and Community Services, Inc. (“CFCS”) and refused to let a party suing CFCS have access to the assets of the Archdiocese of Phoenix. Ruling in favor of the separate existence of these two corporations, the Court gave us guidance in how far the Archdiocese in its capacity as a “parent” company could go in maintaining influence over the activities of CFCS as its “subsidiary” company. The Court’s specific findings are remarkably helpful to our present planning effort.

The Bishop established CFCS to assist families in the adoption process. The Taegers sued CFCS and the Diocese because the CFCS staff lied to them about the health problems of the natural mother of the child the Taegers adopted through CFCS. The Court allowed a jury trial against CFCS but dismissed the case against the Diocese because CFCS was a separate corporation. It is significant to note that CFCS had been established by the Diocese specifically to avoid liability of the Diocese for the activities of CFCS. In reaching this result, the Court placed great weight on the fact that the Bishop did not exercise day-to-day control over CFCS or its board of directors. In ruling for the Diocese, the Arizona Court of Appeals specifically:

• Allowed the bishop to appoint 25 percent of the members of the board of CFCS as a subsidiary company.
• Allowed the bishop to exercise “ecclesiastical control” (so long as the bishop did not dictate the day-to-day decisions of CFCS).
• Allowed the bishop to ensure that CFCS follows the principles of the Roman Catholic Faith so long as the Articles of Incorporation did not empower the bishop to direct the president or the employees of CFCS to take any particular (day-to-day) action.
• Approved the practice of having CFCS and the Diocese filing joint financial statements since the standard for filing a combined financial statement is not the equivalent of the control standard for determining whether one corporation is an alter ego of another.

The Taeger case teaches that it is legally permissible in Arizona for the Church to establish a separate company to isolate risk activities for the sole purpose of protecting the assets of the Church. This arrangement was specifically upheld by the Court, noting on page 37 of its opinion that:

The Taegers’ expert, LeRoy Gaintner (“Gaintner”), testified that one of the bases for his opinion was that CFCS amended its articles of incorporation because it was concerned about the need to limit the Diocese’s exposure to liability for the acts of CFCS. Additionally, Paul Martodam (“Martodam”), the current director of CFCS, testified that the board amended CFCS’s articles of incorporation to make clear that liability for CFCS’s acts could not run to the Diocese. Finally, the Diocese’s attorney, Gregory J. Leisse (“Leisse”), testified that Pecharich wanted to amend CFCS’s articles of incorporation to eliminate any potential claim that the Diocese was liable for CFCS’s acts.

A critical question in the minds of many of your congregation and of the church board will be whether or not the establishment of a separate company to own and operate the school–for example, will allow a rogue board to ignore important Scriptural principles? And in a similar vein, could a rogue Board of the Land Holding Company cancel the lease to the church and sell the property to a shopping center developer? Simply put, if the church board authorizes the establishment of separate companies for this purpose, will it violate its basic stewardship principles by allowing control of the campus to pass from the present board to the new board of directors of the land-holding company? This is a legitimate question and requires a careful, thoughtful answer.

There are a series of powerful safeguards that can be incorporated into the structure to alleviate this fear. These include:

• Requiring that a majority of all members of the subsidiary boards have prior service on the church board.
• Allowing the church board to appoint 25 percent of the members of the subsidiary boards. An interlocking directorate may be used. (i.e., Some, but preferably not a majority, of the board members of the land-holding corporation may also serve on the board of the church.)
• Requiring the church board approve all nominees for the new boards.
• Follow the Taeger case in allowing the church board power to exercise “ecclesiastical control” (so long as the board does not dictate the day-to-day decisions of the subsidiary). The Church Board may ensure that the subsidiary follows the principles of the Christian faith, so long as the Articles of Incorporation do not empower the church board to direct the president or the employees of the subsidiary to take any particular (day-to-day) action. (These limitations will be contained in the Articles of Incorporation and the Bylaws of the subsidiary company.)
• Some of the officers and directors may serve as officers and directors of both companies at the same time, although it would be best to be sure that the same people do not occupy all of the positions in both companies.
• Using a deed to transfer title from the church to the land-holding company that contains significant use restrictions.
• Inserting strict limitations in the use clause of the leases and shared occupancy agreements.

A review of the case law in Arizona (and from other jurisdictions) clearly indicates that these steps are legally permissible, so long as the foundation board does not exercise day-to-day control over the acts of the church, and, vice versa, that the church’s board of directors does not exercise day-to-day control over the acts of the Land Holding Company.

• Each company should have its own checking account and independent operating budget.
• Separate corporate records must be maintained.
• Care must be taken to use separate logos and stationery so that the public will know that they are dealing with separate companies.
• Each company must have adequate insurance and some assets. (i.e., Do not create a “shell” company with no assets.)

In the structure described above, it is anticipated that the church would transfer title to the campus to the land-holding company, subject to placing certain deed restrictions on the deed that transfers title. These restrictions would limit the use of the campus to the conduct of a Christian faith-based ministry on the campus. (Query: Will this be tied to the Lutheran denomination or not?)

The land-holding company will simultaneously sign a lease with the church granting the church the right to use and occupy the property subject to similar use restrictions. The point of these restrictions is to reduce the market value of the property so that if someone did obtain a judgment against the church, for example, the ability to resolve the case would be greatly enhanced by the fact that the property could not be taken and its use converted to a shopping center, apartments or other lucrative use.

By necessity, this memo raises many questions to be answered in the planning and legal/accounting phase of this review process. Hopefully, this will spur your church board to carefully consider the use of a multiple company structure to:

1. Maximize the board’s ability to resist an unjust claim;
2. Grant the board the discretion to have the resources to pay a just claim;
3. Not create an unwieldy corporate structure; and
4. Maintain conformity to the church doctrine.

Obviously, each church faces unique legal and accounting issues, so these articles must be considered only as a starting point and must be reviewed by legal and tax advisers who have a knowledge of your specific situation and the laws of your jurisdiction. These articles have been written from the perspective of an Arizona law; the laws of your jurisdiction may differ, so consult with local counsel.

For more information about this article, contact Bob at 602.992.6725.