A federal district court in Kansas ruled that the protections of the Church Audit Procedures Act did not apply to an Internal Revenue Service (IRS) summons seeking access to a church’s financial records maintained by its bank.
The backstory
A church founded in 2009 by a married couple (the pastor and his spouse) “self-declares” as a church rather than filing an application for Recognition of Exemption under Section 501(c)(3) of the Internal Revenue Code (IRS Form 1023).
This church operates a thrift store that accepts donated goods and sells them to the public, and has a small space in its thrift store set up as a coffee shop.
In February 2021, the IRS assigned an agent to determine whether the church engaged in prohibited political campaign intervention, and if a “church tax inquiry” was warranted.
The assignment covered the period of January 1, 2019, through December 31, 2020.
In June2021, the Commissioner of the Tax Exempt and Government Entities Division approved the agent’s request to open an inquiry.
The agent issued a Notice of Church Tax Inquiry (“NCTI”) informing the church there were concerns the church:
- was operating as a thrift shop, rather than as a church;
- may have engaged in prohibited political campaign intervention in 2020;
- may be liable for unrelated business income tax (“UBIT”) from the operation of a coffee shop in 2019 and 2020; and
- may be liable for additional Form 941 employment taxes for wages paid to the founding couple in 2019 and 2020.
The NCTI included a list of questions for the church from the IRS, but it did not request any documents.
In July 2021, the church responded with answers to the questions, and it provided copies of various documents.
After reviewing the church’s response, the agent still had concerns about the church’s tax-exempt status as a church, possible liability for UBIT, and liability for additional taxes under the Internal Revenue Code.
The agent then sought and received approval to begin a church tax examination, which was approved by the Commissioner in September 2021. The agent issued a Notice of Church Tax Examination (“NCTE”) to the church on September 7, 2021. It informed the church that the IRS continued to have concerns. The NCTE also included, among other things, a description of the church records and activities that might need to be examined and an offer of a pre-examination conference.
On October 14, 2021, the agent and his group manager conducted a pre-examination conference with the church’s authorized representative. The pre-examination conference did not resolve the IRS’s concerns, so it notified the church’s representative that the IRS would be moving forward with the examination.
Later that month, the agent issued an Information Document Request (“IDR”) to the church seeking a number of things, including copies of the church’s bank statements from January 1, 2019, to December 31, 2020.
The church responded that the request was overly broad and objected to producing the bank statements.
In December 2021, the agent sent IRS Letter 3164-E to the church advising of the IRS’s intent to contact third parties during a contact period spanning January 22, 2022, to January 22, 2023, as part of the IRS’s examination. The letter informed the church of its right to request a list of people contacted.
On December 22, 2022, the agent sent a letter to the church indicating the documents requested in the IDR, including bank statements, were delinquent, and issued a second IDR seeking the church’s bank statements.
In February 2022, the agent issued a summons to the church’s bank seeking 14 separate categories of the bank’s records from all accounts in the church’s name for the period of January 1, 2019, through December 31, 2020. Specifically, the summons requested:
(1) Monthly statements;
(2) Deposit offsets (front and back);
(3) Deposit tickets;
(4) Cancelled checks (front and back);
(5) Signature cards;
(6) Debit and credit memos;
(7) Loan applications, including lines of credit, and all documents related to loan(s);
(8) Financial statements;
(9) Safe deposit box entry cards;
(10) Cashier’s checks and applications;
(11) Money orders;
(12) Foreign and domestic letters of credit and wires of funds along with related documents disclosing source of funds and, for wires of funds, the destination of the funds along with any related correspondence;
(13) Agency agreements and correspondence; and
(14) Closing transaction on the account (check, wire transfer, and so on, regardless of amount).
In March 2022, a representative of the church’s bank informed the agent that the bank had collected documents as directed by the summons, but those documents were being held pending resolution of the church’s petition to “quash” the summons (in other words, have it voided through a legal process).
General principles regarding IRS summons
Section 7602 of the tax code authorizes the IRS to summons a witness to testify and to produce books, papers, records, or other data that may be relevant or material to an investigation. Section 7602 also identifies the purposes for which the IRS may issue summonses. The purposes are:
- To ascertain the correctness of any return;
- To prepare a return where none has been made;
- To determine the liability of a person for any internal revenue tax;
- To determine the liability at law or in equity of a transferee or fiduciary of a person in respect of any internal revenue tax;
- To collect any internal revenue tax liability; or,
- To inquire into any offense (civil or criminal) connected with the administration or enforcement of the internal revenue laws.
Meanwhile, section 7609 of the tax code authorizes the IRS to issue a summons seeking specified records of a third party, such as a taxpayer’s bank.
The IRS explains: “A third-party summons is a summons directed to a person other than the person with respect to whose liability or return the summons is issued, or any officer or employee of such person.” (Internal Revenue Manual 25.5.6.3.1)
In issuing a summons, the IRS must act “in good faith.” The IRS demonstrates it issued a summons in good faith by establishing:
- the investigation will be conducted pursuant to a legitimate purpose,
- that the inquiry may be relevant to the purpose,
- that the information sought is not already within the [IRS’s] possession, and
- that the administrative steps required by the [Internal Revenue Code] have been followed—in particular, that the Secretary or his delegate, after investigation, has determined the further examination to be necessary and has notified the taxpayer in writing to that effect.
These four requirements are known as the “Powell factors” (named after a federal appeals court decision that first articulated them).
The IRS can demonstrate good faith by submitting an affidavit from the investigating agent.
The taxpayer, however, has an opportunity to challenge that affidavit, and to urge the court to quash the summons “on any appropriate ground.” Grounds can include an improper purpose.
Impact of the Church Audit Procedures Act (Tax Code Section 7611)
The church argued that the Church Audit Procedures Act applied to the third-party record keeper summons that the IRS served upon its bank and placed limits on the IRS’s examination of the records sought by the summons.
Church tax inquiries
The Church Audit Procedures Act restricts the IRS when conducting church tax inquiries and church tax examinations. It provides, in pertinent part, that the IRS may begin a “church tax inquiry” only if it meets reasonable belief and notice requirements:
- The reasonable belief requirement is met if “an appropriate high-level Treasury official reasonably believes (on the basis of facts and circumstances recorded in writing) that the church–(A) may not be exempt, by reason of its status as a church, from tax or may be carrying on an unrelated trade or business … or otherwise engaged in activities subject to taxation … .”
- The notice requirement is met if, before beginning such inquiry, the Secretary of the Treasury Department provides written notice to the church of the beginning of such inquiry, and an explanation of the concerns which gave rise to such inquiry, and the general subject matter of such inquiry, and a general explanation of the applicable administrative and constitutional provisions with respect to such inquiry (including the right to a conference with the Secretary before any examination of church records), and provisions of this title which authorize such inquiry or which may be otherwise involved in such inquiry.
Church tax examinations
A “church tax examination” is any examination, for purposes of making a church tax inquiry, of church records at the request of the IRS, or the religious activities of any church. The Church Audit Procedures Act restricts the IRS with respect to church tax examinations. It provides a church tax examination by the IRS may be made only:
- in the case of church records, to the extent necessary to determine the liability for, and the amount of, any tax imposed, and
- in the case of religious activities, to the extent necessary to determine whether an organization claiming to be a church is in fact a church for any period.
The Church Audit Procedures Act defines “church records” to mean “all corporate and financial records regularly kept by a church, including corporate minute books and lists of members and contributors.” And, it exempts from the definition of “church records” any records acquired pursuant to a third party summons. IRC 7611(h)(4)(B)(i).
Deciding the church’s request to quash
The court concluded that the third-party summons seeking the church’s banking and financial records “fell squarely” within this exception to the definition of church records, meaning that the church’s objection to the summons of its bank records was unfounded.
Enforcement of the IRS’s third-party summons to the church’s bank “is therefore governed by section 7609 through application of the Powell factors [see above] and is not subject to the additional restrictions on church tax examinations set forth in section 7611 of the Church Audit Procedures Act, notwithstanding the summons was issued in conjunction with a church tax inquiry and examination.”
Notably, “the plain language of [the Act] expressly excludes records obtained from third-party record keepers—such as banks—from the definition of ‘church records’.”
The tax regulations provide that “records held by a third-party record keeper bank are not ‘church records,’ and access to such records is permitted through a third-party summons under section 7609, without complying with the procedures in section 7611” pertaining to the Church Audit Procedure Act.
Therefore, the Internal Revenue Service may request a church to provide information necessary to locate third-party records (for instance, bank records), including information regarding the church’s chartered name, state and year of incorporation, and location of checking and savings accounts, without application of the procedures of section 7611. . . .
Records (for instance, cancelled checks or other records in the possession of a bank) held by third party record keepers, as defined in section 7609, are not considered church records. Thus, subject to the provisions set forth in section 7609 regarding third party summonses, access is permitted to such records without regard to the requirements of the procedures set forth in section 7611.
Having made this determination, the court then addressed whether the IRS had demonstrated that the summons was issued in good faith under the four-factor test articulated in Powell.
The first Powell factor requires that the IRS show “the investigation will be conducted pursuant to a legitimate purpose,” and the second Powell factor requires the IRS show “the inquiry may be relevant to the purpose.” The IRS asserted that the “books, papers, records, and other data sought by the summons may be relevant” to the following purposes:
Determine whether [the Church] was operating as a thrift shop rather than as a church or whether [the Church] may have unrelated business income and therefore may be liable for UBIT. Further, the information may be relevant to identify bank accounts used by [the Church]. Identifying bank accounts used by [the Church] in turn may also be relevant to determine whether [the Church] may have engaged in prohibited political campaign intervention in 2020, may have unrelated business income and therefore may be liable for UBIT from the operation of a coffee shop in 2019 and 2020, and may be liable for additional Form 941 employment taxes for wages paid to [the pastor and his wife] in 2019 and 2020.
The court concluded that “the IRS’s stated purposes … are clearly consistent with the IRS’s duty and authority to make the inquiries, determinations, and assessments of all taxes … imposed by [the Internal Revenue Code]. The IRS has satisfied its initial burden to show it is conducting its investigation pursuant to a legitimate purpose or purposes under the first Powell factor and the inquiry may be relevant to those purposes under the second Powell factor.”
The court found that the records sought by the IRS summons also satisfied the third and fourth Powell factors (the information sought by the IRS is not already within its possession, and the administrative steps required by the tax code have been followed).
What this means for churches
This case illustrates the authority of the IRS to seek records from third parties (including banks) pertaining to a church’s tax status and liabilities. This authority is not affected by the fact that a summons seeking third-party records was issued in conjunction with a church tax inquiry and examination.
The case also is helpful because it is one of the few federal court rulings to address the meaning and application of the Church Audit Procedures Act.
Church v. United States, 2022 WL 17830849 (D. Kan. 2022).