United States: IRS Proposes To Raise The Rank Of Official Initiating Church Tax Inquiries, But Not High Enough

This article was originally published in Caplin & Drysdale Exempt Organizations Alert, August 31, 2009

Following a setback in federal court earlier this year, the Treasury and the Internal Revenue Service ("IRS") have proposed to amend their regulations to reassign authority within the IRS to approve various aspects of church tax inquiries and examinations. The proposed regulations were published in the August 5, 2009 issue of the Federal Register.

The government's stated purpose in proposing these amendments is to update the "Q&A" explanation of section 7611 of the Internal Revenue Code to reflect the IRS's statutorily-mandated reorganization in 1998 from a geographic hierarchy to one with divisions based on type of taxpayer. Section 7611 and the regulations interpreting it impose special internal procedural rules on IRS examinations of churches, out of respect for the First Amendment concerns that arise whenever the government subjects religious groups to undue scrutiny or supervision. These rules require specific officials within the IRS to receive notice of or approve various aspects of tax inquiries and examinations of churches, but those officials no longer exist as a result of the 1998 restructuring. In particular, the 7611 rules prohibited the IRS from launching a church tax inquiry unless one of four IRS Regional Commissioners with authority for all tax administration within a particular region, or a higher official (i.e., the Commissioner or Deputy Commissioner of Internal Revenue), first determined that there were reasonable grounds for such an inquiry. This rule helped to ensure that someone with policy-making authority and political accountability could weigh the needs of tax administration against the First Amendment concerns with IRS intrusion into church affairs.

Without officially updating its regulations, the IRS has until recently been assigning the defunct positions' roles under section 7611 to other officials within the new IRS hierarchy. Significantly, the Regional Commissioner's authority to allow initiation of a church tax inquiry was delegated to the much-lower-ranking Director of Exempt Organizations, Examinations ("DEOE").

In United States v. Living Word Christian Center (Jan. 30, 2009), the United States District Court for the District of Minnesota ruled that the delegation to the DEOE was inconsistent with the statutory requirement that a church tax inquiry not be commenced unless a "high-level Treasury Department official" find that there are reasonable grounds for doing so. As the court noted, the officials allowed to make such determinations by statute were no more than one level removed from the Commissioner of Revenue, whereas the DEOE is four levels removed from the Commissioner, and the position's focused responsibility for EO examinations undermines its ability to serve as a high-level outside check on whether such examinations are appropriate in light of First Amendment concerns. The court accorded only limited deference to the IRS's contrary interpretation of the statute, in part because no formal regulation supported the delegation to the DEOE.

The IRS now proposes to modify its regulations to reassign section 7611 authorities to officials in the revised IRS hierarchy, presumably in hopes that such regulations, once finalized, will be sufficient to repel future court challenges to IRS church tax examination procedures. As proposed, the regulations would make three changes:

  1. Give authority previously reserved to the "Regional Commissioner," but delegated to the DEOE post-restructuring, to the Director of the Exempt Organizations Division ("EO Director"), a position only one level above the DEOE. This includes authority, as the "appropriate high-level Treasury official," to determine when there are reasonable grounds to initiate a church tax inquiry and to approve any decision to revoke a church's tax-exempt status.
  2. Substitute Division Counsel/Associate Chief Counsel, Tax Exempt and Government Entities ("TE/GE"), for every mention of the Regional Counsel (another defunct position, post-restructuring). Most notably, this official must receive notice of any church examination before the church does, and must determine whether the IRS is in substantial compliance with the procedural safeguards erected by section 7611.
  3. Eliminate references to the position of Assistant Commissioner (Employee Plans and Exempt Organizations (now defunct) and assign responsibilities to the Commissioner, TE/GE or the Deputy Commissioner, TE/GE. The proposed regulations provide that the Commissioner, TE/GE, or Deputy Commissioner, TE/GE, must approve second inquiries and examinations under section 7611.

C&D's Perspective

In the proposed regulations Treasury and the IRS have nominated the EO Director as the "appropriate high-level Treasury official" to serve as the gatekeeper for initiating church tax inquiries, apparently reversing their previous litigating position that the DEOE is an appropriately high-level official. However, placing this responsibility in the hands of the EO Director still misses the mark. While at first glance it may seem logical to vest this responsibility in the official who is presumably the most familiar with the law governing churches, this delegation of authority is problematic for two reasons.

First, the position, three levels removed from the Commissioner of Internal Revenue, is not sufficiently "high-ranking" to be considered comparable to the former Regional Commissioner, and thus violates the statute. The 7611 procedures ensure that officials in a position to consider the broad policy implications of their actions make the decision to initiate the church tax inquiry and are a key component of the set of the statutory safeguards that Congress enacted to protect churches from overly intrusive IRS review. Because of the sweeping First Amendment implications of the taxation of religious institutions, it is especially important that these decisions be made by high-level officials, who are appropriately removed from the normal audit process, to ensure that churches receive the protections Congress intended them to have.

Second, the EO Director is functionally quite different from the former Regional Commissioner, in ways likely to make the EO Director too personally invested in the success of the Exempt Organizations Division's audit program to be expected to make independent, objective judgment calls of this nature. In the IRS organizational structure prior to the restructuring in 1998, the Regional Commissioner had a position outside the regular flow of exempt organizations tax administration. In contrast, the EO Director is charged with approving, issuing and overseeing the annual EO workplan. The success of the workplan in addressing EO compliance problems is, therefore, inevitably part of the performance evaluation of the position, creating a real tension between the role of "chief enforcer" of exempt organizations tax law and the role of "independent evaluator" of the appropriateness of a particular church inquiry.

Given that the reasonableness decision can never be challenged, in court or administratively, the assignment of the responsibility for that decision to the EO Director removes the only element of review that was outside the EO stovepipe, a particularly important fact given that section 7611 removes the only other possibility of independent evaluation, the right to an administrative appeal and review in the IRS Office of Appeals. It seems inappropriate and out-of-step with the underlying philosophy of section 7611 to provide less of a check-and-balance on IRS enforcement than that available to all other taxpayers and tax-exempt organizations.

In short, while the EO Director may be more familiar with exempt organizations than higher-level officials with less direct responsibility for EO tax administration, that familiarity is precisely the concern. To borrow a sports analogy, the EO Director is simply too close to the game. The proposed delegation is like asking the head coach for one team to serve as referee.

The Treasury and the IRS will be accepting comments on the proposed regulations until November 3, 2009.

This article is designed to give general information on the developments covered, not to serve as legal advice related to specific situations or as a legal opinion. Counsel should be consulted for legal advice.

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