Are churches and other houses of worship immune from IRS scrutiny against them and their ministry staff? The current bar is exceedingly high for the IRS to pursue religious institutions (collectively “churches”). But the bar is not insurmountable, particularly when it comes to clergy members’ individual tax liability. The recently decided case of Rowe v. United States demonstrates that churches may be subject to IRS scrutiny, through audits against their clergy members despite special procedural safeguards for such religious institutions.
How the Rowes Got to Court (and Indirectly, Their Church)
The Rowe case involves Herbert and Carol Rowe, a married couple serving as pastors of Upperroom Bible Church in New Orleans, who did not file tax returns from 1996 onward. (That itself is quite a problem!) The IRS eventually found them and came knocking at the Rowes’ door in 2017, asking about tax year 2011 and potential commingling of personal and church funds. Rowes responded by filing a 2011 tax return and providing some bank records. The IRS sought more information through multiple broadly worded summons issued for the church’s additional bank accounts, for which the Rowes held signatory authority.
The Rowes filed motions to quash the IRS’s bank summons. They contended that the summons amounted to an unauthorized church audit in violation of the federal Church Audit Procedure Act (CAPA). The trial court disagreed. Instead, the court validated the IRS’s ability to scrutinize the Rowes’ clergy compensation and found that CAPA applies only to church audits, not clergy members.
Special Protections for Church Tax Audits – “High-Level” Approval Needed
CAPA was enacted in 1984 and is codified as Section 7611 of the Internal Revenue Code. Section 7611 limits the manner in which the IRS may conduct church tax inquiries of religious institutions, in recognition of both the important religious liberty interests at stake for churches and the IRS’s potential abuse of them. Section 7611 thus limits the IRS’s ability to initiate audits of religious institutions that it suspects may not actually qualify for tax-exempt status under Section 501(c)(3), may be carrying on a taxable unrelated business activity, or otherwise be subject to taxation. More specifically, the IRS must comply with special notice procedures under Section 7611 in order to begin auditing a religious institution, and such an audit may be authorized only by a sufficiently high-ranking Treasury official.
Identifying just who can satisfy this authorization requirement has proved troublesome for the IRS. Section 7611 defines the “appropriate high-level Treasury official” who can authorize a church audit as “the Secretary of the Treasury or any delegate of the Secretary whose rank is no lower than that of a principal Internal Revenue officer for an internal revenue region.” IRS regulations, in turn, define “principal Internal Revenue officer” as a “Regional Commissioner.” Therefore, only a person with the rank of Regional Commissioner or higher can authorize a church audit. But the position of “Regional Commissioner” no longer exists, due to an internal IRS reorganization, which make it unclear just what IRS rank is sufficient for investigating churches.
This ambiguity has allowed religious institutions to successfully thwart IRS audits through asserting Section 7611’s procedural protections. For example, a federal trial court agreed in 2008 that the IRS Director of Exempt Organizations Examination (DEOE) did not hold sufficiently high rank to order a church audit. See United States v. Living Word Christian Center (D. Minn. 2008). Much more recently, another federal trial court similarly held that the IRS Director of Exempt Organizations (DEO, one level above the DEOE) was likewise too low in rank to authorize a church tax inquiry. United States v. Bible Study Time, Inc. (D.S.C. March 2018). Notably, however, that court found that the Commissioner of Tax Exempt and Government Entities Division (“TE/GE Commissioner,” one step above the DEO and two steps below the IRS Commissioner) holds the requisite authority to conduct church audits.
The “not high enough rank” approach failed in Rowe. The Court based its decision on the plain language of Section 7611, which “restricts church tax inquiries and examinations, not all investigations that involve a church.” Further, according to Section 7611(h)(4)(A), protected “church records” “shall not include records acquired pursuant to a summons to which section 7609 applies” (i.e., summonses to third parties rather than to churches themselves). The Court also noted that “courts routinely hold that Section 7611 protects churches from inquiry into their tax liability, but does not insulate them from summonses issued in connection to an investigation of a third party, such as a church employee.” In doing so, the Rowe court cited several cases including a prior 2017 decision from the Bible Study Time, Inc. v. United States case, which likewise held that Section 7611 does not apply to IRS audits of individual taxpayers involved with religious organizations.
What Section 7611 and Rowe Mean for Religious Institutions – What Happens If the IRS Comes Knocking?
For now, religious institutions remain largely protected from IRS scrutiny, but they are not untouchable. However difficult the Section 7611 authorization requirement may be to satisfy, Rowe demonstrates such protection is not bullet-proof. In Rowe, the IRS was able to access church financial information to determine whether the clergy members, and the church– violated income tax laws. How should religious institutions respond to the court’s decision in Rowe? Here are some takeaways.
1. Follow the Rules (Consistent with Sincerely Held Religious Beliefs)
Religious adherents and religious institutions should abide by the ethical principles of their faith traditions by being submissive to secular authorities, as required under the law. As the Christian scriptures put it: Christians are to “be subject to the governing authorities, for there is no authority except that which God has established.” (Romans 13:1) Religious groups need to comply with applicable payroll requirements and other laws, including tax laws, albeit subject to their leaders’ governing consciences.
2. Keep Excellent Records that Demonstrate Legal Compliance
Rowe’s court-sanctioned IRS access to church financial records, in order to scrutinize the church’s compensation practices for its two clergy members, provides a strong warning to all religious institutions with respect to their payroll practices. More specifically, because religious institutions hold financial resources as charitable assets, both they and their paid workers are subject to various tax and other laws grounded in trust principles, which require that their employees be paid reasonable compensation and not be allowed to abuse such charitable resources (whether intentionally or inadvertently). Wise religious leaders thus should care for their clergy by carefully complying with applicable employee payroll requirements, and thoroughly documenting the religious institution’s compliance. This involves approving housing allowances for an entire year in advance, performing due diligence to accurately determine suitable compensation, as discussed below, and carefully documenting that due diligence to prove that the religious institution is not permitting the clergy person to benefit impermissibly.
3. Review Clergy Compensation Carefully
How do payroll troubles arise with the IRS? Two key payroll pitfalls are “excess benefit transactions” (EBT) and “automatic” EBTs. Generally speaking, EBTs arise when clergy leaders are paid too-high salaries, bonuses, “love gifts,” as well as impermissible levels of non-cash benefits. In the event of IRS scrutiny, the IRS will make determinations about appropriate compensation levels in its judgment and according to comparable compensation data.
Religious institutions thus should regularly review and guard against improper forms of, and levels of clergy compensation. Some examples include inflated wages, undocumented (or improperly documented) housing allowances, and unduly clergy-favorable housing loans. Automatic EBTs can arise from improperly documented reimbursable expenses, or failure to timely substantiate reimbursable expenses within 60 days after such expenses are incurred. Consequences for regular and automatic EBTs are intentionally punitive, with requirements of repayments and penalties of up to 200% of the allegedly excessive amount. Board members who approve such improper compensatory arrangements, later deemed to be EBTs, may be liable too for a 10% penalty on the excess amount.
4. Define Intellectual Property Ownership Rights Appropriately.
Additional clergy taxable compensation problems may arise in relation to clergy members’ ownership and use of intellectual property, such as sermons, books, and other creative works developed in the course of clergy members’ employment. Under basic “work for hire” legal principles, the religious institution as employer should own such resources, although religious institutions and clergy employees could make other arrangements such as employee ownership of created works with the employer’s unfettered right to use such works. (For more information about intellectual property matters affecting clergy members and religious institutions, see our blog post here) Absent such appropriate arrangements for ownership, usage, and related royalty payment considerations, tax issues may arise that may be addressed through IRS audits of clergy members’ individual compensation and related third-party summons.
Will the IRS Come Knocking?
While an IRS audit is most certainly unusual, religious institutions should not necessarily expect to stay immune from the IRS - completely or indefinitely. The Bible Study Time case shows that the IRS may now have more confidence to initiate church audits nationwide, so long as it can secure the approval of the TE/GE Commissioner. Notably too, the minimum-rank requirement of Section 7611 could be updated and lowered at any time. Ever since the IRS’s defeat in Living Word Christian Center, the IRS has had proposed regulations pending that would clearly identify the DEO as the lowest-ranking IRS official with the authority to order a church audit. These regulatory possibilities, at present, seem unlikely given the current political climate under the Trump Administration.
But rather than relying on Section 7611’s procedural safeguards that may or may not apply, churches seeking to protect themselves and their leadership should not act with impunity when it comes to potential IRS issues. Indeed, the IRS could proceed against a religious institution or individuals improperly, as unfortunately has been known to happen, with headaches and significant resources needed to address such matter. In short, the authorization requirement is far from impossible to satisfy and other variables may factor in, so religious institutions cannot necessarily count on being shielded from IRS inquiry.
Keeping It All in Perspective
Religious institutions definitely enjoy special legal status based on religious liberty protections enshrined in the First Amendment, the Internal Revenue Code itself, and other laws such as under the federal and many states’ Religious Freedom Restoration Acts. Religious institutions are a special tax class with unique tax-related protections and benefits. For example, tax-related benefits include tax-exempt status as Section 501(c)(3) public charities, which is accorded without the requirement of an IRS Form 1023 application for affirmative recognition. In addition, religious institutions are exempt from otherwise applicable annual IRS Form 990 filing requirements, which are otherwise applicable to Section 501(c)(3) organizations. And as addressed above, the hurdles to an IRS audit of a religious institution are substantial. Such protections are consistent with our country’s First Amendment commitments related to religious freedoms. (For a framework addressing religious tax exemptions, see our blog post here.
As described above, however, these benefits and protections do not come with immunity. Churches, synagogues, mosques, and other worshipping bodies thus should act responsibly with integrity, awareness of applicable tax and other legal requirements, and consistent legal compliance. That’s a good principle of stewardship anyhow, for religious instutions, their workers, and their leaders too.
 For further guidance in such areas, see https://wagenmakerlaw.com/blog/defying-irs-preaching-ban-good-politics (political campaign activity); https://wagenmakerlaw.com/blog/don%E2%80%99t-get-trumped-%E2%80%93-politics (same); https://wagenmakerlaw.com/blog/when-are-nonprofit-revenues-taxable-ubit-... (unrelated business income tax); and https://wagenmakerlaw.com/blog/would-you-some-%E2%80%9Ccommerciality%E2%80%9D-your-coffee-structuring-tax-exempt-business-activities-under (commercial activities jeopardizing tax-exempt status).