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Time to Reform the Church Audit Procedures Act?

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May the Internal Revenue Service audit religious houses of worship like churches, synagogues, mosques, and temples? Yes, but due to constitutional protections, regulatory guardrails, and the federal Church Audit Procedures Act (“CAPA”), the IRS’s capability to do so is quite constrained – and rightly so. While CAPA offers protection, it is not without significant deficiencies related to audit initiation and accompanying procedures, particularly with respect to obtaining bank records and other information. This article addresses CAPA’s background, requirements, deficiencies, and areas for warranted reform through further government action.

Churches, Congress, and CAPA

As an initial matter, federal tax laws and regulations generally refer to a house of worship as a “church”; such terminology will likewise be used here solely for ease of reference. Additionally, the IRS is very careful to not define the term “church” itself, in light of numerous religious liberty dynamics well beyond the scope of this article.[1] For tax and other purposes, “church” status provides a plethora of legal benefits and implications, such as exclusion from the otherwise applicable IRS Form 990 annual filing requirement. But such benefits do not make churches immune from potential IRS audits or other federal income tax compliance.

Generally speaking, the IRS holds wide-ranging authority under the Internal Revenue Code to scrutinize taxpayers – whether individuals, companies, and even nonprofits – through document requests, review of resulting records, tax assessments, and even punitive measures. Enter CAPA. In 1984, Congress enacted CAPA to ensure that, in the words of Senator Chuck Grassley, “the First Amendment rights of churches are not trampled in the government’s zeal to collect revenue.”[2] Such constitutional rights encompass religion, speech, and assembly rights under the First Amendment. CAPA’s requirements are codified in Section 7611 of the Code.[3] As is standard for federal tax practice, the U.S. Treasury later promulgated regulations in a “Question and Answer” format in an effort to explicate these statutory requirements.[4]

Against this legal framework containing important guardrails, American society can be prone to divisiveness over politics, religion, and conflicting concepts of how best they should interact – or not. To what extent is the IRS susceptible to related influences, for good or for harm? More concretely, are CAPA’s protections still sufficient to protect churches’ constitutional rights and related interests, or were they ever? These questions raise important points for recommended changes to CAPA and other tax reform, particularly in light of recent anecdotal experiences of many tax practitioners involving the IRS and church audits.

CAPA’s Requirements

CAPA’s deficiencies can best be understood through first addressing its requirements. Pursuant to CAPA, the IRS must satisfy the following requirements before it may even contact a church (known as a “church tax inquiry”) or open a formal audit (“a church tax examination”):

1. Approval of a High-Level Treasury Official. An appropriate high-level Treasury official must reasonably believe (on the basis of facts and circumstances recorded in writing) that the church may no longer be exempt as a church or may be engaged in activities subject to taxation. The Code and Treasury Regulations define an appropriate high-level Treasury official as the Secretary of the Treasury or the principal Internal Revenue officer for a region (Regional Commissioner).

2. Notice. The IRS must send the church a written inquiry notice explaining the concerns that gave rise to the inquiry, the general subject matter, and the Code sections that authorize the inquiry. The notice must also inform churches of their right to a conference with the IRS before any examination.

Following the inquiry notice, a church has an opportunity to respond to the IRS’s concerns. If, in the IRS’s view, the concerns are not resolved at the inquiry stage, the IRS may initiate a church tax examination, provided the IRS complies with additional safeguards and limitations designed to protect churches’ First Amendment rights. Specifically, Section 7611 prescribes the following seven substantive and procedural restrictions for church tax examinations.

1. Church Records. The IRS may examine a church’s records only to the extent necessary to determine liability for any tax. Ordinarily, the IRS only need prove that a nonprofit’s records “may be relevant” to an examination.

2. Religious Activities. The IRS may examine a church’s religious activities only to the extent necessary to determine whether the organization is a church.

3. Notice. The IRS must provide written notice containing (a) a copy of the church tax inquiry notice; (b) a description of the church records and activities it seeks to examine; (c) an offer to have a conference to discuss and attempt to resolve the concerns leading to the examination; and (d) a copy of all documents collected or prepared for use in the examination.

4. Limitation on Examination Period. Church tax examinations must be completed within two years of the examination notice date. This deadline may be suspended in the case of a judicial proceeding, the church’s failure to comply with reasonable requests for church records, or by mutual agreement.

5. Regional Counsel Approval. The IRS may revoke a church’s tax-exempt status or send a notice of tax deficiency only if the appropriate regional counsel determines in writing that the Service has complied with CAPA’s requirements and approves the revocation or assessment.

6. Statute of Limitations. For examinations involving church status, the IRS may examine only the three most recent taxable years. For examinations involving unrelated business income tax, the IRS may examine the six most recent taxable years.

7. Limited Repeat Examinations. If a church tax inquiry or examination does not result in a revocation or an assessment, the IRS may not initiate a new inquiry or examination for a five-year period.

CAPA’s Deficiencies Warranting Clarification and Correction

Although CAPA may have been intended to offer substantial protection for churches, its efficacy has been severely hampered by the IRS’s reorganization after its enactment along with vagueness and inconsistencies in its accompanying tax regulations. These problems hinder churches from sufficiently understanding and pursuing constitutional and procedural safeguards that should be available. CAPA’s most troubling deficiencies involve both definitional and operational aspects, as follows.

Defining “High-Level” Treasury Official

CAPA’s most powerful safeguard is likely its requirement that an IRS inquiry may commence only begin if a sufficiently “high-level” Treasury official forms a “reasonable belief,” on the basis of written facts, that a church may no longer be tax-exempt as a church or may be subject to a tax. The Treasury Regulations state that an IRS Regional Commissioner possesses the minimum level of qualification to make the reasonable belief determination. Problematically, however, the IRS eliminated the position of Regional Commissioner in its 1998 restructuring.

Practitioners, scholars, and judges have observed that Section 7611’s congressional intent was to ensure that the IRS official making the requisite reasonable belief determination both (1) possessed sufficient experience to make high-level, sensitive policy judgments and (2) was not directly involved in church tax enforcement.[5] The Regional Commissioner position was only one hierarchal step down from the Commissioner of the Internal Revenue Service – very high indeed. Additionally, Regional Commissioners did not directly oversee church tax enforcement and possessed the requisite perspective to form a reasonable belief.

Since the IRS’s 1998 restructuring, the IRS has delegated and redelegated the “reasonable belief” finding requirement to different positions within the IRS’s Tax Exempt and Government Entities Division (“TEGE”). At present, the IRS is relying on a district court case and an internal “delegation order” as settled authority that the TEGE Division Commissioner satisfies the sufficiently high-level Treasury criteria.[6] But the TEGE Commissioner arguably lacks the breadth of multi-divisional experience that the former Regional Commissioner held, and the ranks of the two are difficult to understand. Some contend that the IRS Deputy Commissioner for Services and Enforcement—the position above the TEGE Commissioner—is a more proper parallel under the IRS’s current organizational structure.

Does this really matter? Yes! The IRS’s current delegation approach completely bypasses public participation requirements of the otherwise mandatory Administrative Procedures Act,[7] which contain numerous safeguards that are not optional for the IRS or any other federal agency. Considering the constitutional rights of churches involved, the IRS’s refusal to comply with such otherwise applicable legal requirements raises especially troubling due process and related fairness concerns, particularly if the IRS comes proverbially knocking at church doors – or threatens to do so. Stated differently, any church audited by the IRS (or concerned that it will be audited) lacks clarity as to whether the IRS’s examination of its religious activities and records is properly authorized and therefore legally permissible. Notably, such concerns extend as well as any records held by third parties, such as bank and other financial records, which may be subject to the IRS’s subpoena power exercised through court action.

Admittedly, the IRS has barely touched churches through any formal inquiry or tax examinations. Indeed, between October 1, 2020, and September 30, 2022, the IRS opened only fourteen church tax examinations, which amounts to 0.2% of the IRS’s total exempt organizational examinations commenced during this timeframe. Perhaps due to this quite small percentage, the federal government’s neglect in this area can be understandable. But nevertheless, legal clarity remains vitally important, especially when First Amendment rights are involved.

“Church Records” and “Religious Activities”

CAPA and the corresponding IRS regulations set forth two distinct categories of examinations with separate safeguards and procedural requirements: examinations of “church records” and examinations of “religious activities.” The IRS may examine church records to determine liability for any tax and examines religious activities to determine church status. But neither the Code nor the Regulations define “religious activities.”

Functionally, church records and religious activities often overlap. A church’s congregational meeting minutes, financial records, and donor lists fall under the statutory definition of “church records,” but does that mean that they should not be used to scrutinize a church’s tax-exempt status? If so, are there limits on when church records alone may be used to evaluate a church’s tax-exempt status? Why do CAPA and its accompanying regulations maintain two separate lines of inquiry for examinations of church status using religious activities and determinations of tax liability using church records?

The significance and utility of these distinct categories merit clarification, with their proper usage circumscribed in church tax inquiries and examinations. Most importantly, as more fully addressed below, it would be helpful to have regulatory examples of the federal tax issues associated with church records and religious activities and their proper use in an examination, rather than the currently vague terminology. This lack of clarity, coupled with the IRS’s potentially enormous power, may lead to a chilling effect when church leaders become unsure how or even if the IRS may scrutinize their religious activities.

Church Records from Third Parties – a/k/a Third-Party Records

The IRS regularly issues requests for records from other parties during examinations (often a “summons”), in order to examine financial and other documents held by third parties in connection with an IRS audit. However, these third-party requests raise additional considerations for churches given CAPA’s heightened protections. Section 7611(h)(4)(B) excludes “summons to which section 7609 applies” from the definition of “church records.” The accompanying tax regulations explain this provision to mean that “access to [third-party] records is permitted without regard to the requirements of the procedures set forth in section 7611.”

However, both the Code and the tax regulations are silent on the relationship between third-party records and religious activities. Third-party records are excluded only from the statutory definition of church records, which are used to assess a tax liability. They are not explicitly excluded from statutory provisions addressing examinations of religious activities to determine church status. This ambiguity raises an additional key question: may the IRS summons third-party records for the purpose of examining a church’s religious activities and determining whether the organization is a church?

In addition, the tax regulations state that a revocation of tax-exempt status or an assessment of unrelated business income tax may not be made “solely” on the basis of third-party records. If so, what is the proper use of third-party records? What does the term “solely” require and how is that safeguard protected? May churches challenge IRS use of third-party records if abused? The Regulations state that “third party bank records will not be used in a manner inconsistent with” Section 7611 or the Regulations. But neither the statute nor the Regulations check the IRS from doing just that.

Lastly, current interpretations of the statute establish a sweeping loophole from the constitutional protections of Section 7611. Although Section 7611(h)(4)(B) excludes third-party records from the definition of church records, it does not address whether Section 7611’s threshold requirement applies to third-party summons. In other words, it does not identify whether an appropriate high-level Treasury official formed a reasonable belief on the basis of written facts in the purposes of the investigation.

It is logical to assume that the IRS should not be issuing third-party summons for records to examine a church’s income tax liabilities or status as a church without properly commencing a church examination. But the language of at least one court opinion appears to have interpreted Section 7611(h)(4)(B) to not require IRS to comply with any of the threshold requirements of CAPA when it issues a third-party summons pursuant to a church tax examination.[8] According to this federal district court opinion, the IRS need not (1) ensure that a high-level Treasury official has formed a reasonable belief or (2) prove that the summonsed documents are necessary for the investigation. Such judicial interpretation allows the IRS to obtain a church’s financial records and other information from third parties, without properly commencing a church tax inquiry or examination. It also allows the IRS to lower the threshold of relevancy from “only to the extent necessary” to “may be relevant” by requesting the same information from a third-party recordkeeper, as opposed to the church itself.

To remedy this very significant problem and threat to church autonomy, one answer is for Congress to close this third-party summons loophole – particularly since the IRS quite clearly will not reform its own processes. Though Section 7611(h)(4)(B) excludes third-party records from the definition of church records, Congress could clarify that the IRS must still comply with the threshold requirements of Section 7611 before issuing third-party summons in connection with an examination. These legislative remedial measures could prevent the IRS from being able to summons a church’s third-party financial records pursuant to an invalid or improper investigation, and thereby better protect churches. In addition, the proper use of third-party records during a church tax examination could be clarified, particularly whether IRS may lower the legal relevancy standard by requesting church financial records indirectly from third parties, rather than the church itself.

Treasury “Question and Answer” Regulations

Section 7611’s accompanying tax regulations set forth a series of nineteen questions and answers. While the IRS commonly uses this format elsewhere in tax guidance, these regulations lack the detailed examples that often accompany and help illustrate such guidance. Many of the deficiencies in the current statutory framework could have been avoided had the regulations followed such customary approach, particularly to provide examples to guide both IRS agents (as they pursue church tax inquiries and examinations) and churches and their attorneys (as they may seek to protect church records and religious activities consistent with appropriate constitutional protections). Any new or otherwise updated regulations thus should include clarifying examples to better address legal compliance and related religious liberty protections.

Final Observations

Congress enacted CAPA to provide both the IRS and churches with structure and constitutional boundaries. But CAPA’s regulations lack sufficient clarity, posing significant adverse implications. The perennial concern that government agencies may be weaponized to accomplish certain agendas seems especially timely now, particularly in light of recent developments involving Congressional scrutiny and earlier efforts to increase the IRS’s staffing exponentially.[9] Should CAPA be reformed? Absolutely! How and when? Such matters warrant careful attention and well-deserved follow-through steps. For now, all churches, synagogues, mosques, and other houses of worship should take church tax status accountability seriously.

[1] For information about “church” classification under the Internal Revenue Code and related considerations, see Defining Church with an IRS Focus and Religious Tax Reclassification of Public Charities.
[2] Church Audit Procedures Act: Hearing Before the Subcomm. on Oversight of the I.R.S. of the S. Comm. On Finance, 98th Cong. 2 (1983).
[3] As is common with many Code sections, Section 7611 is structured negatively – that is, no IRS audit (“inquiry”) may commence unless certain condition are met, as follows:

(a) Restrictions on inquiries:

(1) In general - The Secretary may begin a church tax inquiry only if — (A) the reasonable belief requirements of paragraph (2), and (B) the notice requirements of paragraph (3), have been met.

(2) Reasonable belief requirements. The requirements of this paragraph are met with respect to any church tax inquiry 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 under section 501(a), or (B) may be carrying on an unrelated trade or business (within the meaning of section 513) or otherwise engaged in activities subject to taxation under this title.

[4] See 26 CFR § 301.7611-1.
[5] J. Michael Martin, Why Congress Adopted the Church Audit Procedures Act and What Must Be Done Now to Restore the Law for Churches and the IRS, 29 Akron Tax Journal 1, 16-17 (2014) (collecting comments); Amendments to the Regulations Regarding Questions and Answers Relating to Church Tax Inquiries and Examinations; Hearing, 74 Fed. Reg. 59; United States v. Living Word Christian Ctr., No. CIVA 08MC37(ADMJJK), 2008 WL 5456381, at *11 (D. Minn. Nov. 18, 2008), report and recommendation adopted, No. CIV. 08-MC-37ADM/JJK, 2009 WL 250049 (D. Minn. Jan. 30, 2009).
[6] United States v. Bible Study Times, 295 F. Supp. 3d 606 (D.S.C. 2018); IRM (06-23-2020) Delegation Order 7-3.
[7] Enacted by Congress in 1946, the APA’s purposes were as follows: (1) to ensure that agencies keep the public informed of their organization, procedures, and rules, (2) to provide for public participation in the rule-making process, (3) to prescribe uniform standards for the conduct of formal rule making and adjudicatory proceedings, and (4) to restate the law of judicial review. Administrative Procedures Act (See also full text and related information).
[8] See United States v. C.E. Hobbs Found. for Religious Training & Educ., 7 F.3d 169 (9th Cir. 1993); Bible Study Time v. United States, 240 F. Supp. 3d 409 (D.S.C. 2017).
[9] See S.1777 - 117th Congress; see also an article addressing the U.S. House of Representatives’ scrutiny of an IRS agent’s “unannounced home visit” to a journalist; New U.S. House Weaponization Panel to Probe FBI, IRS, ATF; and other related articles on IRS hiring here and here.

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