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Independence and Religious Institutions: A Short History Lesson on Federal Tax Exemption

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Some people celebrate Independence Day with fireworks. As a nonprofit tax attorney, I prefer to contemplate our country’s rich history of income tax exemption accorded to our nation’s religious institutions. (And then head for the holiday picnic and sparklers!) 

A.Start at the Beginning

Our country’s religious institutions have been exempt from taxes since before the Unites States was even birthed. Such treatment is consistent with worldwide historical treatment of religious institutions as exempt. As the U.S. Supreme Court observed in the 1970 landmark case of Walz v. Tax Commission:

Few concepts are more deeply embedded in the fabric of our national life beginning with pre-revolutionary colonial times, than for the government to exercise at the very least this kind of benevolent neutrality toward churches and religious exercise generally, so long as none was favored over others and none suffered interference.

As U.S. Supreme Court Justice O’Connor further observed in the 1997 City of Boerne v. Flores case, the early American leaders “accorded religious exercise a special constitutional status,” with consensus that “government interference in religious practice was not to be lightly countenanced.”

Two critical tax principles are implicated here. First as Justice Marshall famously pointed out long ago, “the power to tax involves the power to destroy.” McCulloch v. Maryland(1819). Second, the power to tax is that of a sovereign. Religious institutions may be subject to the sovereign in limited ways (e.g., payroll taxes, health and safety regulations), but all such intrusions must be strictly scrutinized and guarded against overreaching. Many constitutional scholars thus agree that religious institutions are exempt from income taxes as a constitutional right, not a privilege.

B.To Tax (Income) or Not to Tax?

With the advent of corporate income taxation starting in 1909, Congress specifically exempted “corporations, companies, or associations organized and conducted solely for charitable, religious, or educational purposes.” No information tax returns whatsoever were required for any tax-exempt organizations until the 1943 Revenue Act. Again, the new law specifically exempted “religious organization[s]” and organization[s] ... operated, supervised, or controlled by or in connection with a religious organization.” 

Over the next several years, new laws were passed to impose taxes and related reporting requirements on unrelated business activities of all tax-exempt organizations, including religious institutions. The rationale for applying these new legal requirements to religious institutions is that such commercial activity is qualitatively different from sacerdotal functions and religious worship. Such activity therefore operates to remove otherwise applicable First Amendment protections, but solely for such commercial, non-religious activities.

C.Special IRS Reporting Privileges

When the Tax Reform Act of 1969 was passed, it reflected a continuing deference to religious institutions as being autonomous and free from governmental intrusion (except, as stated above, for commercial activities) in two notable ways. First, the 1969 Act added Section 508 to the Internal Revenue Code, requiring new nonprofit organizations to apply for an official determination of tax-exempt status except for religious institutions, their integrated auxiliaries, and conventions or associations of churches (i.e., non-hierarchal churches). Second, the 1969 Act imposed new annual information return requirements on schools, colleges, and publically supported charities. Again, however, the new law reaffirmed the exemption requirement for religious institutions, their integrated auxiliaries, and conventions or associations of churches.

Fast forward to the 21st century. In the wake of financially successful “megachurches” and scandals involving abuse of religious institutions, extensive demands have been made for unprecedented stepped-up IRS scrutiny of religious institutions and specifically through the vehicle of IRS Form 990 reporting. It is unknown whether such demands are borne of religious animus or arise from other illegitimate considerations, as the recent IRS scandal has demonstrated.

D.What Next?

Regardless, they serve as a dual warning for religious institutions. First, they must be more vigilant than ever in protecting their long-held and precious religious liberties from taxation and related scrutiny. Second, they should continue to demonstrate integrity, service, and value to their communities and society in general, to help justify this great privilege.

For more information about constitutional protections of religious institutions from IRS scrutiny, particularly with respect to IRS Form 990 reporting and constitutional protections therefrom, please see the our article Should Religious Institutions Be Required to File Form 990s?, which was prepared for the Evangelical Council for Financial Accountability’s sponsored blue-ribbon “Commission on Accountability and Policy for Religious Organizations” in 2012, in response to U.S. Senator Charles Grassley’s 2011 staff report on media-based ministries.  

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