Religious Corporation's Attempt to Block IRS Summons Rejected by Federal District Court

Key point. The tax code provides several protections available to churches in the event the IRS serves notice of a "church tax inquiry" or "church tax examination."

A federal district court in South Carolina rejected an attempt by a religious corporation to block an IRS summons seeking the production of the corporation's bank records at eight banks.

A religious corporation (the "plaintiff") was incorporated as a nonprofit entity in 1972. In its early years, the plaintiff's primary function was to produce and broadcast a weekly radio program. At some point, the plaintiff began a weekly faith-based television program. In 2015, the plaintiff was informed by the IRS that it had been selected for audit and that the IRS would be seeking access to its bank records. The plaintiff's accountant informed the IRS agent in charge of the audit that the plaintiff was claiming church status and all the protections of the Church Audit Procedures Act (section 7611 of the tax code). In response, the IRS sent the plaintiff a "notice of church tax inquiry" listing the following areas of concern:

• Whether the plaintiff had engaged in excess benefit transactions with disqualified persons. The IRS noted that the plaintiff's chief officer was paid $371,445 in "reportable compensation" plus an additional $48,000 in "other compensation," described as a parsonage allowance. The next highest paid employee received compensation of $125,596, consisting of a base salary and "commission income based on a fixed percentage of broadcast placement revenue."
• Whether the plaintiff had received unrelated (and unreported) business income from the rental of various properties.
• Whether all compensation was properly reported on W-2s.
• Whether the plaintiff's claim of church status was warranted.

The notice asked for several items of information regarding the plaintiff's religious activities, revenue and expenses, and detailed information on compensation paid to the officers. The plaintiff did not respond to these inquiries on the ground that the IRS officer who signed the notice was "director, exempt organizations," and not a "high level IRS official" required to sign any notice of church tax inquiry by section 7611 of the tax code.

The IRS informed the plaintiff that "because you did not provide the information we requested, we still think an examination of the organization's books and records may be necessary." This letter identified the same concerns previously noted (possible excess benefit transactions, receipt of unrelated business income, failure to report all compensation, and claim of church status).

Rather than further pursuing a church tax examination, the IRS issued summonses to the plaintiff's banks in 2016. The plaintiff sought to quash the eight summonses on the following grounds:

(1) The purpose was improper because the summonses were issued in support of a church tax inquiry that was not properly authorized under section 7611.

The court noted that section 7611 of the tax code, which incorporates the Church Audit Procedures Act, defines a "church tax inquiry" as "any inquiry to a church to serve as a basis for determining" whether the church is exempt from tax due to its status as a church or is subject to taxation for some other reason (e.g., because it is carrying on an unrelated trade or business). IRC 7611(h)(2).

Section 7611 defines a "church tax examination" as any examination of (A) Church Records at the request of the IRS, or (B) the religious activities of any church. IRC 7611(h)(3). "Church Records" is defined to exclude records acquired "pursuant to a summons to which Section 7609 applies." IRC 7611(h)(4). "Thus, church tax inquiries and church tax examinations are two distinct investigatory tools used for the same purpose and are directed to the church or to records in the church's custody (as opposed to church-related records held by a third party)."

The court continued:

Presumably because church examinations are more intrusive, section 7611 provides that a church must be offered a conference before a church tax examination is conducted. Church records and activities may, moreover, only be examined "to the extent necessary to determine" liability for tax or whether the entity was, in fact, operating as a church during the relevant period ….

Third-party summonses are governed by section 7609, not section 7611, even when the summons is issued in connection with a church tax inquiry …. Legislative history confirms that section 7611 is inapplicable to third-party summonses …. The House Conference report [in connection with section 7609] stated the "church audit procedures" did not apply to examination of the types of third-party records sought here, explaining as follows: "Records held by third parties (e.g., cancelled checks or other records in the possession of a bank) are not considered church records for purposes of the conference agreement. Thus … the IRS is permitted access to such records without regard to the requirements of the church audit procedures.

(2) The IRS failed to provide the plaintiff with the required tax inquiry notice before issuing the summonses.

The plaintiff claimed that the IRS had failed to provide proper notice that it might seek information from third parties. The court disagreed, noting that the IRS has provided the plaintiff with this information by providing it with a copy of IRS Publication 1, which advises taxpayers that the IRS may "sometimes talk with other persons if we need information that you have been unable to provide."

(3) The summonses violate section 7611's prohibition on repetitive church inquiries.

The court noted that "if any church tax inquiry or examination with respect to any church is completed and does not result in [an adverse consequence] no other church tax inquiry or examination may begin with respect to such church during the applicable 5-year period unless such inquiry or examination is approved in writing by the Treasury Secretary or does not involve the same or similar issues involved in the preceding inquiry or examination." IRC 7611(f)(1).

The court concluded that occasional correspondence from the IRS that did not constitute church tax inquiries did not count in applying this provision.

What this means for churches

This case provides a helpful review of some of the protections of the Church Audit Procedures Act that were set forth in section 7611 of the tax code. They may be summarized as follows:

Tax inquiries and examinations of churches

Congress has imposed special limitations, found in section 7611 of the tax code, on how and when the IRS may conduct civil tax inquiries and examinations of churches. The IRS may only initiate a church tax inquiry if an appropriate high-level Treasury Department official reasonably believes, based on a written statement of the facts and circumstances, that the organization: (a) may not qualify for the exemption or (b) may not be paying tax on an unrelated business or other taxable activity.

Restrictions on church inquiries and examinations

Restrictions on church inquiries and examinations apply only to churches and conventions or associations of churches. They don't apply to related organizations. For example, the rules don't apply to schools that, although operated by a church, are organized as separate legal entities. Similarly, the rules don't apply to integrated auxiliaries of a church.

Restrictions on church inquiries and examinations do not apply to all church inquiries by the IRS. The most common exception relates to routine requests for information. For example, IRS requests for information from churches about filing of returns, compliance with income or Social Security and Medicare tax withholding requirements, supplemental information needed to process returns or applications, and other similar inquiries are not covered by the special church audit rules.

Restrictions on church inquiries and examinations don't apply to criminal investigations or to investigations of the tax liability of any person connected with the church, such as a contributor or minister.

The procedures described in section 7611 are used in initiating and conducting any inquiry or examination into whether an excess benefit transaction has occurred between a church and a pastor or other insider.

Audit process

The sequence of the audit process is:

• If the reasonable belief requirement is met, the IRS must begin an inquiry by providing a church with written notice containing an explanation of its concerns.
• The church is allowed a reasonable period in which to respond by furnishing a written explanation to alleviate IRS concerns.
• If the church fails to respond within the required time, or if its response is not sufficient to alleviate IRS concerns, the IRS may, generally within 90 days, issue a second notice, informing the church of the need to examine its books and records.
• After issuance of a second notice, but before commencement of an examination of its books and records, the church may request a conference with an IRS official to discuss IRS concerns. The second notice will contain a copy of all documents collected or prepared by the IRS for use in the examination and subject to disclosure under the Freedom of Information Act, as supplemented by code section 6103 relating to disclosure and confidentiality of tax return information.
• Generally, examination of a church's books and records must be completed within two years from the date of the second notice from the IRS.

If at any time during the inquiry process the church supplies information sufficient to alleviate the concerns of the IRS, the matter will be closed without examination of the church's books and records. There are additional safeguards for the protection of churches under section 7611. For example, the IRS can't begin a subsequent examination of a church for a five-year period unless the previous examination resulted in a revocation, notice of deficiency or assessment, or a request for a significant change in church operations, including a significant change in accounting practices. Bible Study Time v. United States, 2017 WL 897818 (D.S.C. 2017).