Key point 6-03.05. The Church Audit Procedures Act provides churches with a number of important protections in the event of an IRS inquiry or examination. However, there are some exceptions.
Section 7602 of the tax code gives the IRS broad authority to examine or subpoena the books and records of any person or organization for the purposes of (1) ascertaining the correctness of any federal tax return, (2) making a return where none has been filed, (3) determining the liability of any person or organization for any federal tax, or (4) collecting any federal tax. This authority has been held to apply to churches.124 See, e.g., United States v. Coates, 692 F.2d 629 (9th Cir. 1982); United States v. Dykema, 666 F.2d 1096 (7th Cir. 1981); United States v. Freedom Church, 613 F.2d 316 (1st Cir. 1979).
In 1984 Congress enacted the Church Audit Procedures Act to provide churches with important protections when faced with an IRS audit. The Act’s protections are contained in section 7611 of the tax code. Section 7611 imposes detailed limitations on IRS examinations of churches. The limitations can be summarized as follows:
1. Church tax inquiries. Section 7611 refers to church tax inquiries and church tax examinations instead of “audits.” A church tax inquiry is defined as any IRS inquiry to a church (with exceptions noted below) for the purpose of determining whether the organization qualifies for tax exemption as a church or whether it is carrying on an unrelated trade or business or is otherwise engaged in activities subject to tax. An inquiry is considered to commence when the IRS requests information or materials from a church of a type contained in church records.
The IRS may begin a church tax inquiry only if
- an appropriate high-level Treasury official (a regional IRS commissioner, or higher Treasury official) reasonably believes on the basis of written evidence that the church is not exempt (by reason of its status as a church), may be carrying on an unrelated trade or business, or is otherwise engaged in activities subject to taxation; and
- the IRS sends the church written inquiry notice containing an explanation of the following: (1) the specific concerns which gave rise to the inquiry, (2) the general subject matter of the inquiry, and (3) the provisions of the tax code that authorize the inquiry and the applicable administrative and constitutional provisions, including the right to an informal conference with the IRS before any examination of church records, and the First Amendment principle of separation of church and state.
Key point. In 2009 a federal court in Minnesota ruled that the IRS Director of Exempt Organizations (Examinations) was not a “high-level Treasury official” and therefore was not authorized to initiate a church tax inquiry on the basis of a reasonable belief determination that sufficient written evidence existed to warrant a church tax inquiry.125 U.S. v. Living Word Christian Center, 2009 WL 250049 (D. Minn. 2009).The court concluded that only a regional IRS commissioner, or higher Treasury official, qualified as a “high-level Treasury official” as required by the Church Audit Procedures Act. It rejected the IRS’s argument that certain lower-level officials were better qualified to make this determination. This ruling basically shut down IRS efforts to enforce the campaign prohibition by churches.
In 2012 the Freedom From Religion Foundation (FFRF) sued the IRS to compel it to enforce the ban on campaign intervention by churches. It asked the court to authorize a high-ranking official within the IRS to approve and initiate enforcement of the restrictions of section 501(c)(3) against churches and religious organizations, including the electioneering restrictions, as required by law. In 2014 the parties reached a settlement of the case that was approved by the court. The court’s order reads, in part: “The reason the parties seek the dismissal is that the FFRF is satisfied that the IRS does not have a policy at this time of non-enforcement specific to churches and religious institutions.” The FFRF brief in support of the settlement and its motion to dismiss the lawsuit states: “Information received from the Department of Justice … indicated that the IRS has a procedure in place for signature authority to initiate church tax investigations/examinations.”
2. Church tax examinations. The church is allowed a reasonable period in which to respond to the concerns expressed by the IRS in its church tax inquiry. 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 the issuance of a second notice, but before the 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.
The IRS may begin a church tax examination of a church’s records or religious activities only under the following conditions: (1) the requirements of a church tax inquiry have been met; and (2) an examination notice is sent by the IRS to the church at least 15 days after the day on which the inquiry notice was sent, and at least 15 days before the beginning of such an examination, containing the following information: (a) a copy of the inquiry notice, (b) a specific description of the church records and religious activities which the IRS seeks to examine, (c) an offer to conduct an informal conference with the church to discuss and possibly resolve the concerns giving rise to the examination, and (d) a copy of all documents collected or prepared by the IRS for use in the examination, and the disclosure of which is required by the Freedom of Information Act.
Key point. 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.
3. Church records. Church records (defined as all corporate and financial records regularly kept by a church, including corporate minute books and lists of members and contributors) may be examined only to the extent necessary to determine the liability for and amount of any income, employment, or excise tax.
Case study. A federal district court in South Carolina rejected an attempt by a religious corporation to block IRS summonses seeking the production of the corporation’s bank records at eight banks. In rejecting the church’s argument, the court observed:
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.
The court added that “occasional correspondence from the IRS that did not constitute church tax inquiries does not count” in applying the Church Audit Procedures Act’s prohibition of repeat inquiries addressing the same issue within a 5-year period. Bible Study Time v. United States, 2017 WL 897818 (D.S.C. 2017).
4. Religious activities. Religious activities may be examined only to the extent necessary to determine whether an organization claiming to be a church is, in fact, a church.
5. Deadline for completing church tax inquiries. Church tax inquiries not followed by an examination notice must be completed not later than 90 days after the inquiry notice date. Church tax inquiries and church tax examinations must be completed not later than two years after the examination notice date. The two-year limitation can be suspended (1) if the church brings a judicial proceeding against the IRS; (2) if the IRS brings a judicial proceeding to compel compliance by the church with any reasonable request for examination of church records or religious activities; (3) for any period in excess of 20 days (but not more than six months) in which the church fails to comply with any reasonable request by the IRS for church records; or (4) if the IRS and church mutually agree.
Key point. A federal appeals court ruled that the revocation of a church’s tax-exempt status by the IRS could not be challenged on the ground that the IRS’s examination of the church exceeded the two-year limit imposed by the Church Audit Procedures Act.126 Music Square Church v. United States, 2000-2 USTC ¶50,578 (Fed. Cir. 2000).The court noted that the Act specifies that “no suit may be maintained, and no defense may be raised in any proceeding … by reason of any noncompliance by the [IRS] with the requirements of this section.”
6. Written opinion of IRS legal counsel. The IRS can make a determination, based on a church tax inquiry or church tax examination, that an organization is not a church that is exempt from federal income taxation, or that is qualified to receive tax-deductible contributions, or that otherwise owes any income, employment, or excise tax (including the unrelated business income tax), only if the appropriate regional legal counsel of the IRS determines in writing that there has been substantial compliance with the limitations imposed under section 7611 and approves in writing of such revocation of exemption or assessment of tax.
7. Statute of limitations. Church tax examinations involving tax-exempt status or the liability for any tax other than the unrelated business income tax may be begun only for any one or more of the three most recent taxable years ending before the examination notice date. For examinations involving unrelated business taxable income, or if a church is proven not to be exempt for any of the preceding three years, the IRS may examine relevant records and assess tax as part of the same audit for a total of six years preceding the examination notice date. For examinations involving issues other than revocation of exempt status or unrelated business taxable income (such as examinations pertaining to employment taxes), no limitation period applies if no return has been filed.
8. Limitation on repeat inquiries and examinations. If any church tax inquiry or church tax examination is completed and does not result in a revocation of exemption or assessment of taxes, then no other church tax inquiry or church tax examination may begin with respect to such church during the five-year period beginning on the examination notice date (or the inquiry notice date if no examination notice was sent) unless such inquiry or examination is (1) approved in writing by the Assistant Commissioner of Employee Plans and Exempt Organizations of the IRS, or (2) does not involve the same or similar issues involved in the prior inquiry or examination. The five-year period is suspended if the two-year limitation on the completion of an examination is suspended.
Case study. A federal district court in South Carolina ruled that “occasional correspondence from the IRS that does not constitute church tax inquiries does not count” in applying the Church Audit Procedures Act’s prohibition of repeat inquiries addressing the same issue within a 5-year period. Bible Study Time v. United States, 2017 WL 897818 (D.S.C. 2017).
9. Exceptions. The limitations on church tax inquiries and church tax examinations do not apply to
- inquiries or examinations pertaining to organizations other than churches (the term church is defined by section 7611 as any organization claiming to be a church, and any convention or association of churches; the term does not include separately incorporated church-affiliated schools or other separately incorporated church-affiliated organizations).
- any case involving a knowing failure to file a tax return or a willful attempt to defeat or evade taxes.
- criminal investigations.
- the tax liability of a contributor to a church, or inquiries regarding assignment of income to a church or a vow of poverty by an individual followed by a transfer of property.127 See, e.g., St. German of Alaska Eastern Orthodox Catholic Church v. Commissioner, 840 F.2d 1087 (2nd Cir. 1988); United States v. Coates, 692 F.2d 629 (9th Cir. 1982); United States v. Life Science Church of America, 636 F.2d 221 (8th Cir. 1980); United States v. Holmes, 614 F.2d 895 (5th Cir. 1980); United States v. Freedom Church, 613 F.2d 316 (1st Cir. 1979).
- the tax liability of pastors and other church staff members.128 See, e.g., Thomas F. v. Commissioner, 101 T.C.M. 1550 (2011); Pennington v. U.S. 2010 WL 417410 (W.D. Tex. 2010).
- routine IRS inquiries, including (1) the filing or failure to file any tax return or information return by the church; (2) compliance with income tax or FICA tax withholding; (3) supplemental information needed to complete the mechanical processing of any incomplete or incorrect return filed by a church; (4) information necessary to process applications for exempt status, letter ruling requests, or employment tax exempt requests; or (5) confirmation that a specific business is or is not owned by a church.
10. Extension of audit protections to church payroll compliance. In the past, the IRS did not apply the protections of section 7611 to employment tax inquiries in which it sought to determine a church’s compliance with payroll tax reporting requirements. The current copy of the IRS Internal Revenue Manual specifies: “Section 7611 procedures do not apply to employment tax inquiries.”
However, on December 17, 2015, the IRS issued an internal memorandum “to provide clarification for and updates to [IRS examiners’] responsibilities regarding employment tax examinations of churches.” The IRS memo notes that “prior to this guidance memo [IRS agents] were instructed that section 7611 procedures do not apply to employment tax inquiries.” The IRS memo amends the Internal Revenue Manual with the insertion of the following new section 4.23.2.13(2): “Section 7611 procedures apply to employment tax inquiries. Examiners should not initiate any examinations on a church. If for some reason an employment tax examiner encounters a church employment tax issue, the examiner should immediately contact the Program Manager, Exam, Programs and Review (EPR) in TE/GE Exempt Organizations Examinations.”
The amendment is effective immediately and will be incorporated into the next revision of the Internal Revenue Manual.
11. Application to excess benefit transactions. For many years, the IRS asked Congress to provide a remedy other than outright revocation of exemption that it could use to combat excessive compensation paid by exempt organizations. In 1996 Congress responded by enacting section 4958 of the tax code. Section 4958 empowers the IRS to assess intermediate sanctions in the form of substantial excise taxes against insiders (called “disqualified persons”) who benefit from an excess benefit transaction.
Section 4958 also allows the IRS to assess excise taxes against a charity’s board members who approved an excess benefit transaction. These excise taxes are called “intermediate sanctions” because they represent a remedy the IRS can apply short of revocation of a charity’s exempt status. While revocation of exempt status remains an option whenever a tax-exempt organization enters into an excess benefit transaction with a disqualified person, it is less likely that the IRS will pursue this remedy now that intermediate sanctions are available.
The tax regulations specify that
the procedures of section 7611 will be used in initiating and conducting any inquiry or examination into whether an excess benefit transaction has occurred between a church and a disqualified person. For purposes of this rule, the reasonable belief required to initiate a church tax inquiry is satisfied if there is a reasonable belief that a section 4958 tax is due from a disqualified person with respect to a transaction involving a church. 129 Treas. Reg. 53.4958-8(b).
12. Remedy for IRS violations. If the IRS has not complied substantially with (1) the notice requirements, (2) the requirement that an appropriate high-level Treasury official approve the commencement of a church tax inquiry, or (3) the requirement of informing the church of its right to an informal conference, the church’s exclusive remedy is a stay of the inquiry or examination until such requirements are satisfied.
The fact that the IRS has authority to examine church records and the religious activities of a church or religious denomination does not necessarily establish its right to do so. The courts have held that an IRS summons or subpoena directed at church records must satisfy the following conditions to be enforceable.
13. Issued in good faith. Good faith in this context means that (1) the investigation will be conducted pursuant to a legitimate purpose; (2) the inquiry is necessary to that purpose; (3) the information sought is not already within the IRS’s possession; and (4) the proper administrative steps have been followed. In United States v. Powell, 379 U.S. 48 (1964), the United States Supreme Court held that in order to obtain judicial enforcement of a summons or subpoena, the IRS must prove “that 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 in the Commissioner’s possession, and that the administrative steps required by the tax code have been followed.” Powell did not involve an IRS examination of church records. In United States v. Holmes, 614 F.2d 985 (5th Cir. 1980), a federal appeals court held that section 7605(c) narrowed the scope of the second part of the Powell test from mere relevancy to necessity in the context of church records, since it required that an examination of church records be limited “to the extent necessary.” The “necessity test” should apply to church inquiries or examinations conducted under section 7611, since the same language is employed.130 United States v. Church of Scientology, 90-2 U.S.T.C. ¶ 50,349 (D. Mass. 1990).
14. No violation of the church’s First Amendment right to freely exercise its religion. An IRS subpoena will not violate a church’s First Amendment rights unless it substantially burdens a legitimate and sincerely held religious belief and is not supported by a compelling governmental interest that cannot be accomplished by less restrictive means. This is a difficult test to satisfy, not only because few churches can successfully demonstrate that enforcement of an IRS summons or subpoena substantially burdens an actual religious tenet, but also because the courts have ruled that maintenance of the integrity of the government’s fiscal policies constitutes a compelling governmental interest that overrides religious beliefs to the contrary.131 See, e.g., St. German of Alaska Eastern Orthodox Catholic Church v. Commissioner, 840 F.2d 1087 (2nd Cir. 1988); United States v. Coates, 692 F.2d 629 (9th Cir. 1982); United States v. Life Science Church of America, 636 F.2d 221 (8th Cir. 1980); United States v. Holmes, 614 F.2d 895 (5th Cir. 1980); United States v. Freedom Church, 613 F.2d 316 (1st Cir. 1979).
15. No impermissible entanglement of church and state. 132 See generally United States v. Coates, 692 F.2d 629 (9th Cir. 1982); United States v. Grayson County State Bank, 656 F.2d 1070 (5th Cir. 1981); EEOC v. Southwestern Baptist Theological Seminary, 651 F.2d 277 (5th Cir. 1981) (application of 1964 Civil Rights Act’s reporting requirements to seminary did not violate First Amendment).Federal law provides that if the IRS wants to retroactively revoke the tax-exempt status of a church, it must show either that the church “omitted or misstated a material fact” in its original exemption application or that the church has been “operated in a manner materially different from that originally represented.”133 Treas. Reg. 601.201(n)(6)(i).
Although IRS authority to examine and subpoena church records is broad, it has limits. To illustrate, one subpoena was issued against all documents relating to the organizational structure of a church since its inception; all correspondence files for a three-year period; the minutes of the officers, directors, trustees, and ministers for the same three-year period; and a sample of every piece of literature pertaining to the church.134 United States v. Holmes, 614 F.2d 985 (5th Cir. 1980). See also United States v. Trader’s State Bank, 695 F.2d 1132 (9th Cir. 1983) (IRS summons seeking production of all of a church’s bank statements, correspondence, and records relating to bank accounts, safe deposit boxes, and loans held to be overly broad).A court concluded that this subpoena was “too far reaching” and declared it invalid. It noted, however, that a “properly narrowed” subpoena would not violate the First Amendment. Another federal court that refused to enforce an IRS subpoena directed at a church emphasized that “the unique status afforded churches by Congress requires that the IRS strictly adhere to its own procedures when delving into church activities.”135 United States v. Church of Scientology of Boston, 739 F. Supp. 46 (D. Mass. 1990).The court also stressed that the safeguards afforded churches under federal law prevent the IRS from “going on a fishing expedition into church books and records.”