Federal Income Taxation of Churches

By Richard R. Hammar, J.D., LL.M., CPA

© Copyright 1991, 1998 by Church Law & Tax Report.  All rights reserved.  This publication is designed to provide accurate and authoritative information in regard to the subject matter covered. It is provided with the understanding that the publisher is not engaged in rendering legal, accounting, or other professional service.  If legal advice or other expert assistance is required, the services of a competent professional person should be sought. Church Law & Tax Report, PO Box 1098, Matthews, NC 28106. Reference Code: m69

[c]orporations . . . organized and operated exclusively for religious, charitable . . . or educational purposes . . . no part of the net earnings of which inures to the benefit of any private shareholder or individual, no substantial part of the activities of which is carrying on propaganda, or otherwise attempting, to influence legislation . . . and which does not participate in, or intervene in (including the publishing or distributing of statements), any political campaign on behalf of any candidate for public office.¹

The quoted section exempts churches from federal income taxation. Note that the exemption is conditioned upon the following six factors: (1) the church is a corporation, (2) the church is organized exclusively for exempt purposes, (3) the church is operated exclusively for exempt purposes, (4) none of the church's net earnings inures to the benefit of any private individuals, (5) the church does not engage in substantial efforts to influence legislation, and (6) the church does not intervene or participate in political campaigns. These factors will be considered individually. They have been upheld despite the occasional claim that they constitute impermissible “conditions” on the constitutional guaranty of religious freedom.²

(1) The Church Is a Corporation

While the Internal Revenue Code would appear to exempt only those churches that are incorporated, the IRS maintains that unincorporated churches are eligible for exemption. In its Exempt Organizations Handbook, the IRS states that “the typical nonprofit association formed under a constitution or bylaws, with elective officers empowered to act for it, would be treated as a corporation . . . .”³ This is consistent with the definition of corporation contained in section 7701(a)(3) of the Internal Revenue Code, and with federal court decisions interpreting the term corporation to mean any organization satisfying at least three of the four principal corporate characteristics of centralized control, continuity, limited personal liability, and transferability of beneficial interests.⁴

(2) The Church Is Organized Exclusively for Exempt Purposes

To be exempt from federal income tax, a church must be “organized exclusively” for exempt purposes. This requirement is referred to by the IRS as the “organizational test” of tax--exempt status. The income tax regulations state that an organization will be deemed to be “organized exclusively” for exempt purposes only if its articles of incorporation⁵ limit the purposes of the organization to one or more of the exempt purposes listed in section 501(c)(3) of the Code and do not expressly empower the organization to engage, otherwise than as an insubstantial part of its activities, in activities that in themselves are not in furtherance of one or more exempt purposes.⁶ Note that the regulations require such limitations to appear in a church's (or other exempt organization's) articles of incorporation, and not in its bylaws.

Section 501(c)(3) of the Code lists the following exempt purposes: religious, charitable, scientific, testing for public safety, literary, educational, fostering national or international amateur sports competition, and prevention of cruelty to children or animals. A church's purposes may be as broad as, or more specific than, the purposes stated in section 501(c)(3). But in no event will a church be considered organized exclusively for one or more exempt purposes if its articles of incorporation recite purposes broader than the purposes stated in section 501(c)(3).⁷ The fact that the actual operation of a church whose purposes are broader than those stated in section 501(c)(3) is exclusively in furtherance of one or more exempt purposes will not be sufficient to permit the church to satisfy the organizational test. Similarly, a church whose purposes are broader than those stated in section 501(c)(3) will not meet the organizational test as a result of statements or other evidence that its members intend to operate it solely in furtherance of one or more exempt purposes. In summary, a church can be organized for purposes other than religious if such purposes are among those listed in section 501(c)(3). At a minimum, however, a church's purposes must be either religious or charitable. The IRS maintains that a church may be organized exclusively for charitable purposes since the term charitable encompasses the advancement of religion.⁸

Section 502 of the Internal Revenue Code states that “[a]n organization operated for the primary purpose of carrying on a trade or business for profit shall not be exempt from taxation under section 501 on the ground that all of its profits are payable to one or more organizations exempt from taxation under section 501.” Such organizations are referred to as feeder organizations. To illustrate, in Revenue Ruling 73--164 the IRS ruled that a church--controlled commercial printing corporation whose business earnings were paid to the church but that had no other significant charitable activity was a feeder organization that did not qualify for exemption under section 501(c)(3). Section 502 specifies that an organization will not be considered to be a feeder organization if (1) its earnings consist of rents that would be excluded from the definition of unrelated business income under section 512 of the Code, (2) substantially all of its work is performed without compensation, or (3) its earnings derive from the selling of merchandise substantially all of which was received as gifts or contributions.

The regulations also specify that an organization is not organized exclusively for exempt purposes unless its assets are dedicated to an exempt purpose, and that an organization's assets will be presumed to be dedicated to an exempt purpose if, upon dissolution, the assets would by reason of a provision in the organization's articles of incorporation be distributed to another exempt organization. Finally, the regulations state that an organization will not be considered organized exclusively for exempt purposes if its articles of incorporation empower it to devote more than an insubstantial part of its activities to attempting to influence legislation, or directly or indirectly to participate in or intervene in any political campaign on behalf of or in opposition to any candidate for public office.⁹

The IRS has drafted the following paragraphs which, if inserted in a church's articles of incorporation, will indicate compliance with the organizational test:

Said corporation is organized exclusively for charitable, religious, [and] educational . . . purposes, including, for such purposes, the making of distributions to organizations that qualify as exempt organizations under section 501(c)(3) of the Internal Revenue Code, or the corresponding section of any future federal tax code.

No part of the net earnings of the corporation shall inure to the benefit of, or be distributable to its members, trustees, officers, or other private persons, except that the corporation shall be authorized and empowered to pay reasonable compensation for services rendered and to make payments and distributions in furtherance of the purposes set forth [herein]. No substantial part of the activities of the corporation shall be the carrying on of propaganda, or otherwise attempting to influence legislation, and the corporation shall not participate in, or intervene in (including the publishing or distribution of statements) any political campaign on behalf of any candidate for public office. Notwithstanding any other provision of these articles, the corporation shall not carry on any other activities not permitted to be carried on (a) by a corporation exempt from Federal income tax under section 501(c)(3) of the Internal Revenue Code, or corresponding section of any future federal tax code, or (b) by a corporation, contributions to which are deductible under section 170(c)(2) of the Internal Revenue Code, or corresponding section of any future federal tax code.

Upon the dissolution of the corporation, assets shall be distributed for one or more exempt purposes within the meaning of section 501(c)(3) of the Internal Revenue Code, or corresponding section of any future federal tax code, or shall be distributed to the federal government, or to a state or local government, for a public purpose. Any such assets not so disposed of shall be disposed of by the Court of Common Pleas of the county in which the principal office of the corporation is then located, exclusively for such purposes or to such organization or organizations, as said Court shall determine, which are organized and operated exclusively for such purposes.¹⁰

One court ruled that a church satisfied the “organizational test” even though its articles of incorporation did not call for the distribution of church assets to other tax--exempt organizations upon dissolution, since (1) the church's minister interpreted his denomination's constitution to call for the distribution of church assets to other churches in the denomination upon dissolution, and (2) state law prohibited church property from being distributed for private use so long as there was someone who would carry on its use for church purposes.¹¹

It is difficult to define what is meant by a religious purpose. The IRS, in its Exempt Organizations Handbook, acknowledges that the term religion cannot be defined with precision. The IRS does acquiesce in federal court rulings defining religion to include beliefs not encompassing a Supreme Being in the conventional sense, such as Taoism, Buddhism, and secular humanism.¹² The IRS also maintains that religion is not confined to a sect or a ritual.¹³ Activities carried on in furtherance of the belief must be exclusively religious. If the activities promote some nonreligious purpose, exemption may be denied. In one case, a court ruled that an organization dominated by one individual was not exempt as a religious organization since its purpose was to carry on the founder's feud with a local newspaper.¹⁴ Religious organizations that engage in substantial legislative activity are disqualified from tax exemption regardless of the motivation or purpose of that activity.¹⁵ Several courts have ruled that religious publishing is a commercial, nonexempt activity regardless of religious motivation if literature is sold to the general public at a profit.¹⁶ But if a religious organization publishes literature to promote its own beliefs, and revenues are used to defray expenses and to further the religious purposes of the organization, the activity is considered to be religious.¹⁷ To illustrate, a federal appeals court ruled that a publishing company that was closely associated (though not legally affiliated) with the Orthodox Presbyterian Church, and whose primary purpose was the publication of books furthering the reformed faith, was exempt.¹⁸

These same principles apply to religious broadcasting activities. For example, one court ruled that a nonprofit religious broadcasting station whose broadcasting time was devoted to worship services and other religious programs and which did not sell commercial or advertising time was exempt.¹⁹

The following activities also have been found to be sufficiently religious in nature to entitle the organization to exempt status: a nonprofit organization formed by local churches to operate a supervised facility known as a coffeehouse in which persons of college age were brought together with church leaders, educators, and businessmen for discussion of religion and current events;²⁰ a nonprofit organization formed to complete genealogical research data on its family members in order to perform religious ordinances in accordance with the precepts of the religious denomination to which family members belonged;²¹ a nonprofit organization that supervised the preparation and inspection of food products prepared commercially in order to ensure that they satisfied the dietary rules of a particular religion, thereby assisting members of the religion to comply with its tenets;²² an organization formed and controlled by an exempt conference of churches that borrowed funds from individuals and made mortgage loans at less than commercial rates of interest to affiliated churches to finance the construction of church buildings;²³ and an organization established to provide temporary low--cost housing and related services for missionary families on furlough in the United States from their assignments abroad.²⁴

Not every organization claiming to be religious is entitled to exemption from federal income taxes. The IRS has denied tax--exempt status to several organizations on the ground that they were not organized exclusively for religious purposes. Illustratively, the following activities have been denied exempt status: a religious organization whose primary activity was the operation of a commercial restaurant;²⁵ a church that engaged in substantial social and political activities;²⁶ an organization incorporated for religious purposes but which conducted no religious services and whose primary activity was making investments to accumulate monies for its “building fund”;²⁷ a religious organization offering financial and tax advice to its members or to the public concerning tax savings, often through the creation of a spurious “church”;²⁸ a direct mail religious organization that promised spiritual blessings in exchange for monetary contributions;²⁹ and a “church” consisting of three family members that held Christmas and Easter services but otherwise engaged in no regular or substantial religious activities.³⁰

Charitable purposes, like religious purposes, constitute a basis for exemption under the Internal Revenue Code. Many churches define their purposes to include both religious and charitable purposes. The income tax regulations define the term charitable as follows:

Relief of the poor and distressed or of the underprivileged; advancement of religion; advancement of education or science; erection or maintenance of public buildings, monuments, or works; lessening of the burdens of Government; and promotion of social welfare by organizations designed to accomplish any of the above purposes, or (i) to lessen neighborhood tensions; (ii) to eliminate prejudice and discrimination; (iii) to defend human and civil rights secured by law; or (iv) to combat community deterioration and juvenile delinquency.³¹

Churches occasionally engage in activities of a charitable nature. Examples include day--care centers, homes for the aged, orphanages, and halfway houses. Although a church may contend that these activities are religious, it is clear that the IRS views them as charitable.³² Therefore, it is important for a church contemplating any such activities to be sure that its articles of incorporation or other organizing document lists charitable purposes among the purposes of the church.

Similarly, educational purposes, like religious and charitable purposes, constitute a basis for exemption under the Code. The income tax regulations define educational as “[t]he instruction or training of the individual for the purpose of improving or developing his capabilities; or the instruction of the public on subjects useful to the individual and beneficial to the community.”³³

The IRS maintains that even if a school is operated by a church, it is an educational organization if it has a regularly scheduled curriculum, a regular faculty, and a regularly enrolled body of students in attendance at a place where the educational activities are regularly carried on.³⁴ Accordingly, the IRS would view many church--operated primary and secondary schools as educational rather than religious institutions. On the other hand, some courts have ruled that church--operated schools can be considered a religious function.³⁵ Churches that operate schools or preschools should review their articles of incorporation to see if their statement of purposes includes “educational” activities as well as religious activities.

The income tax regulations specify that an organization can be exempt from taxation even if it engages in activities that are not in furtherance of one or more exempt purposes if such activities compose no more than an “insubstantial” part of the organization's total activities.³⁶ Neither the Internal Revenue Code nor the regulations define the term insubstantial. Therefore, this is an issue that must be determined under the facts and circumstances of each case. To illustrate, a charitable organization was determined to be exempt despite its participation in a profit--seeking limited partnership.³⁷ Another organization whose primary purpose was to raise funds for missionaries was found to be exempt despite its subordinate and unrelated activity of distributing 10 percent of its net income in the form of grants and loans to applicants conducting scientific research in the area of energy resources.³⁸ The court emphasized that it was not establishing a general rule that 10 percent was insubstantial. In an earlier decision, the Tax Court had ruled that a religious organization which made cash grants of approximately 20 percent of its net income to private individuals including its officers was not exempt since such grants were more than an insubstantial nonexempt activity.³⁹ The court stated that “while the facts in the instant case merit a denial of exempt status . . . we do not set forth a percentage test which can be relied upon for future reference with respect to nonexempt activities of an organization. Each case must be decided upon its own unique facts and circumstances.”⁴⁰ The Tax Court also denied exempt status to a religious retreat facility on the ground that it was operated primarily for recreational and social purposes, and therefore was engaged to more than an insubstantial degree in nonexempt activities.⁴¹

(3) The Church Is Operated Exclusively for Exempt Purposes

To be exempt from federal income taxes, section 501(c)(3) of the Code requires that a church be “operated exclusively” for exempt purposes. This requirement is referred to as the operational test. The regulations specify that an organization will be regarded as “operated exclusively” for one or more exempt purposes only if it engages primarily in activities that accomplish one or more of the exempt purposes specified in section 501(c)(3), and if no more than an insubstantial part of its activities are not in furtherance of an exempt purpose.

To illustrate, the tax--exempt status of the following religious organizations was revoked on the ground that they were not operated exclusively for exempt purposes: a church--sponsored insurance company that provided members and their families with financial and casualty insurance,⁴² a religious retreat that offered recreational and social activities for a fee similar to those of most other commercial vacation resorts,⁴³ a religious organization that operated a commercial restaurant,⁴⁴ a church that conducted no religious services and whose primary activity was the accumulation of contributions for its building fund,⁴⁵ a church that conducted purely social and political meetings,⁴⁶ and an independent publisher that sold religious literature to the general public at a profit.⁴⁷

A federal appeals court ruled that “profitability” in and of itself does not necessarily mean that an exempt organization is no longer “operated exclusively” for exempt purposes.⁴⁸ To determine whether such an organization should retain its exemption, the court proposed a two--prong test: first, what is the purpose of the organization, and second, to whose benefit do its activities and earnings inure? The court upheld the tax--exempt status of a profitable religious publisher that continued to adhere to its exempt religious purposes and that diverted none of its net earnings to the personal benefit of any individual. The court concluded that “success in terms of audience reached and influence exerted, in and of itself, should not jeopardize the tax--exempt status of organizations which remain true to their stated goals.”⁴⁹

(4) No Inurement of Net Earnings to Private Individuals

A church is not entitled to exemption from federal income taxes if any part of its net earnings inures, or accrues, to the benefit of a private individual. The IRS construes this requirement as follows:

An organization's trustees, officers, members, founders, or contributors may not, by reason of their position, acquire any of its funds. They may, of course, receive reasonable compensation for goods or services or other expenditures in furtherance of exempt purposes. If funds are diverted from exempt purposes to private purposes, however, exemption is in jeopardy. The Code specifically forbids the inurement of earnings to the benefit of private shareholders or individuals. . . . The prohibition of inurement, in its simplest terms, means that a private shareholder or individual cannot pocket the organization's funds except as reasonable payment for goods or services.⁵⁰

Unfortunately, there is very little guidance currently available to help in determining how much income is “reasonable” and therefore appropriate. One federal appeals court concluded that combined annual income of $115,680 paid by a religious organization to its founder and his wife was not excessive.⁵¹ Unreasonable compensation sometimes is associated with payment of clergy compensation based on a percentage of church income. For example, a small church with annual income of $20,000 agrees to pay its minister “one--half” of the church's annual compensation. This amount is certainly reasonable. However, assume that within a few years the church experiences substantial growth and its annual income increases to $500,000. If the church has not changed its method of paying its minister (i.e., the minister now receives annual compensation of $250,000), the IRS would almost certainly conclude that this amounts to unreasonable compensation.

The bankruptcy court in the “PTL” case also addressed the critical issue of what constitutes “reasonable compensation” for a minister.⁵² The bankruptcy court ruled that reasonable compensation for Jim Bakker would have been $133,100 in 1984, $146,410 in 1985, $161,051 in 1986, and $177,156 in 1987. These are the same figures computed by the IRS, and the court openly expressed its reliance upon the IRS data. The court found that Bakker's actual compensation for the four years in question amounted to more than $7.3 million, and that much of this was in the form of “bonuses” and fringe benefits. To illustrate, Bakker's salary (as determined by the court) for the years in question was $228,500 in 1984, $291,500 in 1985, $265,000 in 1986, and $265,000 in 1987. However, the total amount of compensation and benefits attributable to Bakker for the same years was $1.2 million in 1984, $1.6 million in 1985, $1.9 million in 1986, and $2.7 million in 1987.

It is also interesting to review the considerations that influenced the court's determination of reasonable compensation. In answering this question, the court noted that “the highest paid head of a government agency in the State of South Carolina with a salary approved by the legislature is the president of the University of South Carolina who, for the years in question, had a salary under $100,000” (the court undoubtedly overlooked the compensation paid to certain university football and basketball coaches—who also could be considered government employees). The court also referred to the testimony of “expert witnesses” who had testified that normal salary of the highest compensated clergy “would run from $75,000 to $120,000,” and that “bonuses were almost unheard of in the religious field, although fringe benefits would amount to about 30 percent of the salary.” In responding to the view of one of Bakker's witnesses that the Bible mandates that a minister should get 10 percent of all donations and a “high priest” should receive 20 percent, the court commented that such a view “defies common sense and rational judgment.”

The United States Tax Court has addressed the issue of “unreasonable compensation” paid to clergy in a number of decisions. In one case, the Court rejected efforts by the IRS to revoke the tax--exempt status of a church on the basis of “inurement” of its earnings to private individuals.⁵³ The church was a fundamentalist Christian congregation, and its doctrine included a belief in “the death, burial, and resurrection of the Lord Jesus Christ . . . the sovereignty of the Church of God . . . Jesus Christ as the head of the church . . . resurrection of the dead . . . and Jesus Christ coming back again to reign as King of Kings and Lord of Lords over all the earth.” The church, which consisted of about 40 members, conducted worship services three times each week. Regular men's and women's Bible classes were held two or three times each month. Sunday School classes were held every Sunday. Saturday night prayer services were conducted each week. The church's pastor (who was an ordained minister) performed sacerdotal functions, including dedications of children, baptisms, funerals, and marriages.

The IRS audited the church in 1986 (the audit covered the years 1983, 1984, and 1985). At the conclusion of the audit, the IRS revoked the church's tax--exempt status retroactively. The IRS alleged that (1) the church was not operated exclusively for religious purposes, and (2) the church paid “unreasonable compensation” to its minister. The Tax Court rejected the IRS position, and ruled in favor of the church. In rejecting the IRS claim that the church was not operated exclusively for religious purposes, the Court observed:

Petitioner was a small church operating on a modest budget provided by the weekly contributions of its members. Essentially all of its contributions during the audit years were used to pay the mortgage, utility and maintenance expenses on the church building. Its activities primarily consisted of various worship services conducted in the church building and the performance of sacerdotal rites. In our view the [church is operated exclusively for religious purposes].⁵⁴

The Court noted that in 1983, the church received contributions of $10,700 and incurred expenses of $12,200. In 1984 it had contributions of $13,700 and expenses of $13,500. In 1985 it had contributions of $16,200 and expenses of $16,200. The major expenses each year were the mortgage payments, utilities, and repairs on the church building. The mortgage alone amounted to $5,000 of the church's annual budget.

In rejecting the IRS claim that the church paid “unreasonable compensation” to its minister, the Court noted that the pastor was provided a car and an apartment free of charge (a custodian and a caretaker received rent--free apartments on the church's property in exchange for 20 hours of service each week), but otherwise received no salary. The Court observed that in determining

whether compensation is reasonable or excessive . . . one factor to consider is whether comparable services would cost as much if obtained from an outside source in an arm's--length transaction. Applying that standard to the present case, and considering the meager benefits received by the [church's] minister and grounds keepers in return for services that they performed, we find that the benefits were within the bounds of reasonable compensation for those services. Accordingly, there was no inurement of [the church's] net earnings to any private individual . . . .⁵⁵

It is difficult to comprehend why the IRS challenged the tax--exempt status of a church that so clearly qualified for exempt status. Clearly, if the exempt status of this church could be challenged, then few churches are beyond challenge. The Tax Court's decision will be a useful tool in combatting similar efforts in the future.

In other cases, the Tax Court has upheld IRS revocations of the tax--exempt status of churches and other religious organizations. Most of these cases involved “mail order churches” (discussed later in this chapter). To illustrate, the IRS has found private inurement in each of the following situations: a church consisting mostly of family members and conducting few if any religious services paid rent on a residence for the church's ministers, paid for a “church car” that was used by church members, and purchased a “church camp” for church members;⁵⁶ a religious denomination whose assets could be distributed to members upon dissolution;⁵⁷ a church that made cash grants of 20 percent of its income to officers and other individuals based on no fixed criteria and with no provision for repayment;⁵⁸ a church that received almost all of its income from its minister and in turn paid back 90 percent of such income to the minister in the form of living expenses;⁵⁹ a church comprised of three minister--members that paid each minister a salary based on a fixed percentage of the church's gross receipts;⁶⁰ a religious community comprised in part of members who committed all of their possessions to the community and that returned benefits to members in the form of food, shelter, clothing, medical care, educational services, and recreational facilities;⁶¹ a church paid an unreasonable and excessive salary to its pastor;⁶² and the founder of a church who was paid 10 percent of the church's gross income, received a residence and car at the church's expense, and received loans and unexplained reimbursements from the church.⁶³ In the last--cited case, the court held that an organization's net earnings may inure to the benefit of a private individual in ways other than excessive salaries, such as loans. The court also emphasized that the Internal Revenue Code specifies that “no part” of the net earnings of a religious organization may inure to the benefit of a private individual, and therefore the amount or extent of benefit is immaterial.

In conclusion, church leaders should bear in mind the following considerations in planning clergy compensation.

1. Clergy compensation in excess of $100,000 should be carefully reviewed to determine its reasonableness. It would be very appropriate for churches and religious organizations to condition the payment of compensation in excess of $100,000 upon the receipt of a legal opinion (from a tax attorney or independent CPA) certifying that in his or her opinion the level of suggested compensation is not unreasonable. The negative consequences of clergy compensation being classified by the IRS as “unreasonable” are so severe that precautionary measures are desirable.

2. In calculating whether or not a minister's compensation exceeds $100,000, it is important to include all components of compensation (e.g., bonuses, canceled debts, personal expenses paid by the church either by check or credit card, personal use of church vehicles). A church that fails to compute a value for such fringe benefits and include it on the minister's W--2 or 1099 form at the end of the year is jeopardizing its tax--exempt status.

3. Churches never should make loans to clergy at less than market rates of interest. Such loans constitute prohibited inurement of the church's earnings to a private individual. Further, note that loans to clergy who are officers or directors of their church, even at commercially reasonable interest rates, are prohibited by the nonprofit corporation laws of many states.

(5) No Substantial Efforts to Influence Legislation

Section 501(c)(3) of the Internal Revenue Code exempts from federal income taxation a church or religious organization organized and operated exclusively for exempt purposes, and “no substantial part of the activities of which is carrying on propaganda, or otherwise attempting to influence legislation, and which does not participate in, or intervene in (including the publishing or distributing of statements), any political campaign on behalf of any candidate for public office.”⁶⁴ Note that there are two distinct limitations. First, churches may not engage in substantial efforts to influence legislation. Second, churches may not participate or intervene in any political campaign, even to an insubstantial degree. The first of these limitations is addressed in this subsection. The second limitation is addressed in the following subsection.

To be exempt from federal income taxation, no “substantial part” of a church's activities can be the “carrying on of propaganda, or otherwise attempting to influence legislation.” This limitation was enacted by Congress in 1934. Unfortunately, however, it is not entirely clear why the limitation was adopted. The following reasons have been suggested: (1) the exemption from federal income taxation was designed to promote charitable activities, not lobbying; (2) the limitation is required to preserve the constitutional principle of separation of church and state; (3) Congress was unwilling to permit business organizations, which in 1934 could not deduct lobbying expenses as a business expense, to achieve the same result by deducting contributions to exempt organizations engaged in lobbying activities; and (4) allowing exempt organizations to lobby with tax--free dollars gave them an unfair advantage, in 1934, over nonexempt organizations that were both taxable and unable to deduct lobbying expenditures. One commentator has observed that “it is fair to assume that Congress gave virtually no thought to what it was doing when it enacted the [limitation on legislative activities], and it is highly unlikely that it ever imagined that the [limitation] might be applied to threaten a church.”⁶⁵ Before analyzing this limitation in further detail, it must be emphasized that it is seldom enforced against churches despite many potential violations. For example, many churches and religious denominations have lobbied actively for or against specific legislation concerning civil rights, workers rights, peace, nuclear disarmament, aid to the poor, women's rights, abortion, various treaties, education, sale and advertising of alcoholic beverages, Sunday closing restrictions, sales and property tax exemptions, lotteries, and gambling. Despite the long history of legislative activity, only a few religious organizations have lost their tax--exempt status as a result of “political” activities. Those few cases are discussed in detail later in this subsection and in the following subsection. Nevertheless, in recent years the political activities of churches and religious organizations have been scrutinized more aggressively by the IRS, Congress, the public, and various special interest groups.

Why has the limitation on substantial legislative activity been enforced so infrequently? One reason is the limitation's ambiguity. Specifically, what is meant by the terms legislation, attempts to influence legislation, or substantial? These definitional problems, coupled with the limitation's uncertain purpose and the reluctance of the courts (and to a lesser extent the IRS) to attack the exempt status of churches, have all contributed to the sporadic enforcement of the “legislative activity” limitation.

The income tax regulations, interpreting the legislative activity limitation, provide that neither a church nor any other organization can be exempt from federal income taxation if its charter empowers it “to devote more than an insubstantial part of its activities to attempting to influence legislation by propaganda or otherwise,” or if “a substantial part of its activities is attempting to influence legislation by propaganda or otherwise.”⁶⁶ The regulations further provide that

an organization will be regarded as attempting to influence legislation if the organization (a) contacts, or urges the public to contact, members of a legislative body for the purpose of proposing, supporting,or opposing legislation; or (b) advocates the adoption or rejection of legislation. The term “legislation” . . . includes action by the Congress, by any State legislature, by any local council or similar governing body, or by the public in a referendum, initiative, constitutional amendment, or similar procedure. An organization will not fail to meet the operational test merely because it advocates, as an insubstantial part of its activities, the adoption or rejection of legislation.

This language helps clarify the meaning of legislation and attempts to influence legislation, but does not attempt to define the critical term substantial. The regulations also provide that an organization cannot be exempt if is has the following two characteristics:

The regulations also provide that “the fact that an organization, in carrying out its primary purpose, advocates social or civic changes or presents opinion on controversial issues with the intention of molding public opinion or creating public sentiment to an acceptance of its views does not preclude such organization from qualifying under section 501(c)(3) so long as it [does not violate any of the regulations quoted above].”⁶⁸

The Internal Revenue Manual (the IRS administrative manual) provides the following additional information regarding the limitation on legislative activities:

Attempts to influence legislation are not limited to direct appeals to members of the legislature (direct lobbying). Indirect appeals to legislators through the electorate or general public (indirect or “grassroots” lobbying) also constitute attempts to influence legislation. Of course, whether a communication or an appeal constitutes an attempt to influence legislation is determined on the basis of the facts and circumstances surrounding the communication in question. Both direct and indirect lobbying are nonexempt activities subject to the section 501(c)(3) limitation on substantial legislative action. . . . Similarly, requesting executive bodies to support or oppose legislation is included in the definition of attempting to influence legislation. For purposes of section 501(c)(3), there is no distinction between “good” legislation and “bad” legislation. . . . Although there is contrary precedent, the majority of courts have held that it is not necessary or possible to distinguish between good and bad legislation. Attempts to influence legislation that are less than a substantial part of the organization's activities will not deprive it of exemption. A determination whether a specific activity of an exempt organization constitutes a “substantial” portion of its total activities is a factual one, and there is no simple rule as to what amount of activities is substantial. The earliest case on the subject is of very limited help. That case, Seasongood v. Commissioner, held that attempts to influence legislation that constituted five percent of total activities were not substantial. It provides but limited guidance because the court's view as to what sort of activities were to be measured is no longer supported by the weight of precedent. Moreover, it is not clear how the court arrived at the five percent figure. Most cases either have tended to avoid any attempt at percentage measurement of activities. . . . The central problem is more often one of characterizing the various activities as attempts to influence legislation. Once this determination is made, substantiality is frequently self--evident.⁶⁹

The courts, with one notable exception, generally have held that exempt organizations have not violated the ban on legislative activities. To illustrate, a federal appeals court ruled in 1941 that the Methodist Episcopal Church was exempt despite lobbying activities carried on by its “Board of Temperance, Prohibition and Public Morals,” since such activities were motivated by religious beliefs.⁷⁰ The court observed:

Religion includes a way of life as well as beliefs upon the nature of the world; and the admonitions to be “doers of the word and not hearers only” (James 1:22) and “go ye therefore, and teach all nations” (Matthew 28:19) are as old as the Christian Church. The step from acceptance by the believer to his seeking to influence others in the same direction is a perfectly natural one, and is found in countless religious groups. The next step, equally natural, is to secure the sanction of organized society for or against certain outward practices thought to be essential.⁷¹

Another federal court concluded that a religious organization that had been established to promote observance of the Sabbath was exempt despite its opposition to legislation that would permit commercial activity on Sundays, since such legislative efforts were “incidental” to its religious purposes.⁷² A federal appeals court concluded that a church--related organization was tax--exempt despite the fact that it proposed 36 legislative bills (18 of which were enacted). Again, the legislative activity was considered to be consistent with the organization's exempt status since it all related directly to the organization's religious purposes.⁷³ It should be noted that these decisions were based on the law as it existed prior to the enactment in 1934 of the limitation on legislative activity.

While not involving a church or religious organization, the decision of Seasongood v. Commissioner⁷⁴ is relevant because it is one of the few cases that addresses directly the meaning of the term substantiality. To jeopardize an organization's exempt status, efforts to influence legislation must be substantial. This term, unfortunately, is nowhere defined in the Code or regulations. The court in the Seasongood case concluded that legislative activity is not substantial if it represents only 5 percent or less of an exempt organization's activities. While the 5 percent test has been rejected by the IRS (see the Internal Revenue Manual, quoted above) and by a number of courts, it is still widely regarded as a benchmark of permissible legislative activity by many exempt organizations.

The one case in which a religious organization's tax--exempt status was revoked because of political activities was Christian Echoes National Ministry, Inc. v. United States.⁷⁵ Christian Echoes was a religious organization founded to disseminate conservative Christian principles through radio and television broadcasts and literature. Publications and broadcasts appealed to the public to react to a wide variety of issues in specific ways, including: (1) write their Congressmen in order to influence political decisions; (2) work in politics at the precinct level; (3) support a constitutional amendment restoring prayer in the public schools; (4) demand a congressional investigation of the biased reporting of major television networks; (5) demand that Congress limit foreign aid spending; (6) discourage support of the World Court; (7) cut off diplomatic relations with communist countries; (8) reduce the federal payroll and balance the federal budget; (9) stop federal aid to education, socialized medicine and public housing; (10) abolish the federal income tax; (11) withdraw from the United Nations; (12) restore stringent immigration laws. The organization also attempted to influence legislation by molding public opinion on the issues of firearms control, the Panama Canal treaty, and civil rights legislation.

In 1966, the IRS notified the organization that its exemption was being revoked for three reasons: (1) it was not operated exclusively for charitable, educational, or religious purposes; (2) it had engaged in substantial activity aimed at influencing legislation; and (3) it had directly and indirectly intervened in political campaigns on behalf of candidates for public office. Christian Echoes filed suit in federal court challenging the IRS action, and a federal district court ruled in its favor. This ruling was reversed by a federal appeals court.

The federal appeals court began its opinion by observing that “tax exemption is a privilege, a matter of grace rather than right,” and that the limitations on exempt status set forth in section 501(c)(3) of the Code are valid restrictions on the privilege. The limitations on political activity “stem from the congressional policy that the United States Treasury should be neutral in political affairs and that substantial activities directed to attempts to influence legislation or affect a political campaign should not be subsidized.” The court emphasized that prohibited legislative activity was not limited to attempts to influence specific legislation before Congress. Quoting the income tax regulations (reproduced above), the court concluded that efforts to influence legislation must be interpreted much more broadly, and include all indirect attempts to influence legislation through a “campaign to mold public opinion.” The fact that specific legislation is not mentioned is irrelevant.

The court rejected the “5 percent” test as a measure of “substantial” legislative activities, noting that “[a] percentage test to determine whether the activities were substantial obscures the complexity of balancing the organization's activities in relation to its objectives and circumstances.”

Christian Echoes' contention that revocation of its tax--exempt status violated the constitutional guaranty of religious freedom was rejected by the court. Rejecting the notion that the guaranty of religious freedom “assures no restraints, no limitations and, in effect, protects those exercising the right to do so unfettered,” the court concluded that the limitations on political activities set forth in section 501(c)(3) of the Code were constitutionally valid: “The free exercise clause of the First Amendment is restrained only to the extent of denying tax exempt status and then only in keeping with an overwhelming and compelling governmental interest: that of guarantying that the wall separating church and state remains high and firm.”

From the perspective of many churches, the Christian Echoes decision is unsatisfactory for at least three reasons. First, the court gave an excessively broad definition of the term attempts to influence legislation, including within the term indirect attempts to mold public opinion despite the income tax regulations' statement (quoted above) that an organization's exempt status is not jeopardized if it, in carrying out its primary purpose, “advocates social or civic changes or presents opinion on controversial issues with the intention of molding public opinion or creating public sentiment to an acceptance of its views.” Second, the court rejected the “5 percent” test for determining whether legislative activity is “substantial,” but replaced it with an ambiguous “balancing test.” Churches can never know in advance whether or not their legislative activities are “substantial” under the Christian Echoes standard. Third, the court gave insufficient weight to the constitutional guaranty of religious freedom.

The United States Supreme Court refused to review the Christian Echoes case, and it has not addressed directly the issue of the validity of the limitations on church political activity. However, the Supreme Court has rendered two decisions that are relevant to this issue. First, in a 1970 opinion upholding the constitutionality of state property tax exemptions for church sanctuaries, the Court observed: “Adherents of particular faiths and individual churches frequently take strong positions on public issues including . . . vigorous advocacy of legal or constitutional positions. Of course, churches as much as secular bodies and private citizens have that right.”⁷⁶ This is a recognition that churches have a right to engage in “vigorous advocacy” of legal or constitutional positions. Second, in 1983 the Court was presented with a direct challenge to the constitutionality of the limitation on substantial legislative activity.⁷⁷ Taxation with Representation (TWR), a nonprofit taxpayers rights organization, was denied tax--exempt status by the IRS on account of its legislative activities. TWR appealed to the courts, arguing that the limitation on legislative activities was unconstitutional. The Supreme Court disagreed. Noting that tax exemptions are “a matter of grace that Congress can disallow as it chooses,” the Court concluded that “Congress is not required by the First Amendment to subsidize lobbying.” Significantly, the Court observed that a section 501(c)(3) organization is free to establish an exempt organization under section 501(c)(4) of the Code to conduct lobbying activities. Section 501(c)(4) exempts from federal income taxation those “civic leagues” organized and operated for the “promotion of social welfare.” Such organizations are exempt from tax, and can engage in lobbying, but cannot receive tax--deductible contributions. Accordingly, the Court suggested that TWR establish a separate 501(c)(4) organization to conduct its lobbying activities, and then apply for exemption under section 501(c)(3). The Court noted that “the IRS apparently requires only that the two groups be separately incorporated and keep records adequate to show that tax--deductible contributions are not used to pay for lobbying.”

The legal precedent summarized above suggests several conclusions. They are listed below along with a few additional observations.

1. Churches will jeopardize their tax--exempt status by engaging in substantial efforts to influence legislation. Whether or not particular efforts are “substantial” will depend upon a balancing of the facts and circumstances of each case. Accordingly, churches have no clear standard to guide them. Nevertheless, it is clear that certain activities would be insubstantial, such as the circulation of a few petitions each year addressing legislative issues. Also, it ordinarily is the exempt organization itself that must engage in the legislative activities, not individual members. To illustrate, the IRS has ruled that a university's exempt status was not jeopardized by the legislative activities of a student newspaper.⁷⁸

2. The limitation on legislative activity may violate the constitutional right of churches to exercise their religion. The Christian Echoes decision rejected such a claim, but no other federal court has addressed this issue since the Christian Echoes decision. As noted above, in 1970 the Supreme Court observed that the “[a]dherents of particular faiths and individual churches frequently take strong positions on public issues including . . . vigorous advocacy of legal or constitutional positions. Of course, churches as much as secular bodies and private citizens have that right.”⁷⁹

3. The Christian Echoes decision construed the term attempting to influence legislation very broadly, so as to include all indirect attempts to influence legislation through a “campaign to mold public opinion” even though no specific legislation is ever mentioned. This interpretation seems to contradict the income tax regulations themselves, which provide that an organization's exempt status is not jeopardized if it, in carrying out its primary purpose, “advocates social or civic changes or presents opinion on controversial issues with the intention of molding public opinion or creating public sentiment to an acceptance of its views.” The court's liberal interpretation of the term attempting to influence to legislation has not been endorsed by any other federal court (including the Supreme Court) with respect to a church or religious organization.

4. The Christian Echoes ruling is binding only in the tenth federal circuit (which includes the states of Colorado, Kansas, New Mexico, Oklahoma, Utah, and Wyoming). In addition, in 1976 Congress took the extraordinary step of refusing to approve or disapprove of the Christian Echoes decision.

5. To date, only one religious organization has lost its tax--exempt status for substantial attempts to influence legislation.

6. The United States Supreme Court has suggested that 501(c)(3) organizations desiring to engage in substantial legislative activities should establish a 501(c)(4) exempt organization. Section 501(c)(4) organizations are exempt, and can engage in legislative activities, but they cannot receive tax--deductible contributions.⁸⁰

7. The income tax regulations specify that an organization cannot be exempt from federal income taxation if its charter empowers it to devote more than an insubstantial part of its activities to attempting to influence legislation. The IRS has drafted the following clause that exempt organizations may wish to consider including in their charter or bylaws, which will satisfy this requirement:

No substantial part of the activities of the corporation shall be the carrying on of propaganda, or otherwise attempting to influence legislation, and the corporation shall not participate in, or intervene in (including the publishing or distribution of statements) any political campaign on behalf of or in opposition to any candidate for public office. Notwithstanding any other provision of these articles, the corporation shall not carry on any other activities not permitted to be carried on (a) by a corporation exempt from Federal income tax under section 501(c)(3) of the Internal Revenue Code, or the corresponding provision of any future federal tax code, or (b) by a corporation contributions to which are deductible under section 170(c)(2) of the Internal Revenue Code, or corresponding section of any future federal tax code.⁸¹

8. Finally, in 1976 Congress sought to clarify the meaning of “substantial” legislative activities by enacting section 501(h) of the Code, which gives exempt organizations (other than churches or conventions or associations of churches) the opportunity to elect a congressional definition of “substantial.” Section 501(h) establishes a sliding scale of permissible legislative expenditures. Expenditures in excess of permissible amounts are subject to an excise tax. Loss of exemption is possible if an organization normally spends more than 150 percent of the permissible amounts over a four--year period. To illustrate, an exempt organization that elects coverage under section 501(h) can incur “lobbying expenditures” in an amount equal to 20 percent of the first $500,000 of its “exempt purpose expenditures.” However, no more than one--fourth of this amount can be for “grass roots lobbying” expenditures (i.e., attempts to influence the general public, rather than legislators, on legislative issues). IRS regulations adopted a narrower definition of “grass roots lobbying,” so that the term now includes only (1) explicit “calls to action” on both unnamed and specifically--named legislation, or (2) implicit “calls to action” on specifically--named legislation. The regulations are significant, since they would exclude from the definition of grass roots lobbying any communications (to the public or legislators) not involving an explicit call to action on specifically--named legislation. As noted above, the new regulations will not apply to churches since churches cannot elect coverage under section 501(h). Nevertheless, the exclusion from the definition of grass roots lobbying of any public pronouncements on moral issues not involving a call to action on specifically--named legislation will doubtless be relevant in any future evaluation of church lobbying activities.

The prohibition of more than insubstantial efforts to influence legislation is illustrated by the following examples.

Example. A few times each year, members of First Church circulate petitions among church members following worship services. The petitions enable members to express their support of or opposition to bills pending before Congress or the state legislature. The petitions do not identify the church, and the church itself takes no official position on any of the issues addressed. Such activities clearly do not jeopardize the church's tax--exempt status, for two reasons. First, they are not “substantial.” While this term has not been defined with clarity, it could not reasonably be construed in such a way as to cover the activities that occur at First Church. There is no precedent that suggests that such activities are substantial. They involve neither an expenditure of funds or time by the church. Second, the church itself is not directly involved in the activity. Rather, concerned members of the congregation are simply using the occasion of church services as an opportunity to canvass their fellow members. A church is a public forum, and as such it is an appropriate location for citizens to exercise their constitutional right to petition their government, as long as the church is not involved itself in supporting or opposing specific legislation.

Example. Church members are permitted to post materials addressing legislative issues on a bulletin board at Grace Church. The church does not screen materials placed on the board. This practice will not jeopardize the church's tax--exempt status, since it does not constitute an attempt to influence legislation.

Example. Calvary Church adopts a resolution at a church business meeting expressing support for a constitutional amendment banning abortions. This resolution, by itself, should not jeopardize the church's exempt status, since it does not constitute a “substantial” attempt to influence legislation.

Example. Peace Church permits a group dedicated to nuclear disarmament and world peace to use a room in the church for a two--hour meeting once each month. No rent is charged, and the room would otherwise be vacant if not used by the group. This activity, by itself, will not jeopardize the church's tax--exempt status, since it does not constitute a “substantial” attempt to influence legislation. The church is expending no funds, and allows only a minimal or incidental use of its facilities.

(6) No Intervention or Participation in Political Campaigns

To be exempt from federal income taxation, a church may not “participate in, or intervene in (including the publishing or distributing of statements), any political campaign on behalf of any candidate for public office.” This limitation has an unusual and unfortunate history.⁸² It was proposed in 1954 by then Senator Lyndon B. Johnson of Texas as a floor amendment to the Internal Revenue Code, and passed without explanation. Apparently, Senator Johnson was attempting to limit the political activities of a private foundation that had supported one of his opponents in a Texas election. It is clear that few if any Senators contemplated, in 1954, that the newly--enacted limitation could be used to threaten the tax--exempt status of churches. However, the limitation is worded in absolute terms—prohibiting any attempts by churches or any other tax--exempt organizations to participate or intervene in a political campaign—and therefore does pose a significant threat to churches. Unlike the limitation on attempts to influence legislation, there is no requirement that the participation or intervention in a political campaign be “substantial.” Presumably, one isolated event could be construed as intervention in a political campaign.

Despite the absolute and unconditional language of the prohibition of church intervention in political campaigns, no church has ever lost its exempt status for transgressing this limitation despite numerous flagrant violations. One religious organization that was not a church did lose its exempt status in part because of its intervention in political campaigns.⁸³ In addition, the tax--exempt status of the Roman Catholic Church was challenged, unsuccessfully, by a number of abortion--rights groups because of the Church's alleged intervention in political campaigns.⁸⁴

Why has the IRS been so reluctant to enforce this limitation? A number of explanations are possible. First, there is the constitutional principle of separation of church and state. Second, by failing to enforce the limitation for over three decades, the IRS has induced churches to justifiably assume that the limitation is either nonexistent, or at the least, is not absolute and unconditional. Continued nonenforcement of a statute raises questions as to the statute's legal validity and effect. Third, the meaning of the limitation is unclear. For example, what is the meaning of the terms participation or intervention? Even more fundamentally, how can one distinguish between action by a church, and action by its members or clergy? To illustrate, a campaign representative of Jesse Jackson's 1988 presidential campaign justified church offerings collected specifically for the Jackson campaign on the ground that the appeals were directed to individuals, not churches.

These definitional problems, coupled with the limitation's uncertain purpose and the reluctance of the courts (and to a lesser extent the IRS) to attack the exempt status of churches, have all contributed to the sporadic enforcement of the “electioneering” limitation.

The income tax regulations interpreting the limitation on political campaign intervention provide that neither a church nor any other organization can be exempt from federal income taxation if its charter empowers it “directly or indirectly to participate in, or intervene in (including the publishing or distributing of statements), any political campaign on behalf of or in opposition to any candidate for public office.”⁸⁵ The regulations further provide that:

The term “candidate for public office” means an individual who offers himself, or is proposed by others, as a contestant for an elective public office, whether such office be national, state, or local. Activities which constitute participation or intervention in a political campaign on behalf of or in opposition to a candidate include, but are not limited to, the publication or distribution of written or printed statements or the making of oral statements on behalf of or in opposition to such a candidate.⁸⁶

This regulation provides some clarification. In particular, it clarifies that (1) a “candidate” for public office includes local, state, and national candidates; (2) the prohibited intervention or participation in a political campaign can be satisfied by the mere publication or distribution of a single written statement, or the making of a single oral statement; and (3) statements made in opposition to as well as on behalf of a particular candidate are prohibited.

The Internal Revenue Manual (the IRS administrative manual) provides the following additional information regarding the limitation on political campaign intervention:

Internal Revenue Code section 501(c)(3) precludes exemption for an organization which participates in or intervenes in (including the publishing or distributing of statements) any political campaign on behalf of any candidate for public office. This is frequently referred to as “political” activities. This is an absolute prohibition. There is no requirement that political campaigning be substantial.

The regulations state that political activities include, but are not limited to, the publication or distribution of written or printed statements or the making of oral statements on behalf of or in opposition to a candidate.⁸⁷

These provisions provide the following additional guidance: (1) they emphasize that the prohibition on intervention in political campaigns is absolute—there is no “substantiality” requirement, and (2) they state the IRS position that prohibited political activities are not limited to the publication or distribution of written statements or the making of oral statements on behalf of or in opposition to a candidate.

Neither section 501(c)(3), the regulations, nor the Internal Revenue Manual answers three fundamental questions: (1) Does the dissemination of statements concerning political candidates by ministers or other church representatives solely to church members during worship services, or in church publications distributed to church members, constitute participation or intervention in a political campaign, or must the statements be disseminated on a more widespread basis (i.e., to the public at large)? (2) Under what circumstances can statements made by a minister or other church representative be attributed to the church under the principle of agency? (3) To what extent, if at all, can a church or other exempt organization engage in “voter education” activities without violating the ban on participation in political campaigns? As noted above, no church has lost its tax--exempt status for transgressing the ban on participation in political campaigns, despite numerous apparent violations. However, one religious organization did lose its tax--exempt status in part because it violated this limitation. In addition, the IRS has issued a number of rulings that provide guidance as to voter education activities. All of this legal precedent is summarized below.

The one case in which a religious organization's tax--exempt status was revoked because of political activities is Christian Echoes National Ministry, Inc. v. United States.⁸⁸ Christian Echoes was a religious organization founded to disseminate conservative Christian principles through radio and television broadcasts and literature. While the federal appeals court that upheld the IRS revocation of the organization's exempt status focused primarily on the organization's efforts to influence legislation (discussed in the preceding subsection), it also relied in part on the organization's participation in political campaigns:

In addition to influencing legislation, Christian Echoes intervened in political campaigns. Generally it did not formally endorse specific candidates for office but used its publications and broadcasts to attack candidates and incumbents who were considered too liberal. It attacked President Kennedy in 1961 and urged its followers to elect conservatives like Strom Thurmond . . . . It urged followers to defeat Senator Fulbright and attacked President Johnson and Senator Hubert Humphrey. The annual convention endorsed Senator Barry Goldwater. These attempts to elect or defeat certain political leaders reflected Christian Echoes' objective to change the composition of the federal government.⁸⁹

A disturbing and often--overlooked aspect of this decision is the fact that Christian Echoes lost its exempt status in part because it “attacked President Kennedy in 1961,” even though the next presidential election was three years away. But, the ban on intervention in political campaigns refers specifically to statements made in support of or in opposition to “candidates” for public office. The court apparently concluded that any office holder is a candidate. If this is true, then the ruling effectively prohibits churches and other exempt organizations from ever criticizing any office holder. Fortunately, no other court, or the IRS, has agreed with this result. In fact, a subsequent ruling of the United States Supreme Court seems to repudiate this radical conclusion. In 1978, the Court ruled that business corporations have a constitutional right to speak out on public issues, and therefore it was impermissible for a state to penalize corporations for doing so.⁹⁰ The Court observed that “if a legislature may direct business corporations to `stick to business,' it also may limit other corporations—religious, charitable, or civic—to their respective `business' when addressing the public. Such power in government to channel the expression of views is unacceptable under the First Amendment.” At the least, this language can be read to repudiate the expansive interpretation given by the Christian Echoes court to the limitation on church intervention in political campaigns. It is possible that the Supreme Court's ruling also undermines the entire limitation, though such an interpretation cannot at this time be made with confidence.

Christian Echoes' contention that revocation of its tax--exempt status violated the constitutional guaranty of religious freedom was rejected by the federal appeals court. Rejecting the notion that the guaranty of religious freedom “assures no restraints, no limitations and, in effect, protects those exercising the right to do so unfettered,” the court concluded that the limitations on political activities set forth in section 501(c)(3) of the Code were constitutionally valid:

The free exercise clause of the First Amendment is restrained only to the extent of denying tax exempt status and then only in keeping with an overwhelming and compelling governmental interest: that of guarantying that the wall separating church and state remains high and firm.⁹¹

From the perspective of many churches, the Christian Echoes decision is unsatisfactory for at least two reasons. First, the court gave an excessively broad definition of the limitation on intervention in political campaigns. Second, the court gave insufficient weight to the constitutional guaranty of religious freedom.

As noted previously, the United States Supreme Court refused to review the Christian Echoes case, and it has not addressed directly the issue of the validity of the limitations on church political activity. However, as noted above, its opinion in the Belloti case certainly undermines the validity of the limitations. The Supreme Court declined an opportunity to address the constitutionality of the limitations on church political activity in a case challenging the exempt status of the Roman Catholic Church. Several abortion rights groups had argued that the Church's tax--exempt status should be revoked because of the Church's alleged intervention in political campaigns on behalf of candidates who oppose abortion. A federal appeals court dismissed the lawsuit on the technical ground that the plaintiffs lacked “standing” to litigate the issue.⁹² The United States Supreme Court later declined to review the case.

Finally, several rulings of the IRS have interpreted the ban on interventions in political campaigns, particularly with respect to “voter education” activities. Such rulings demonstrate that certain nonpartisan voter education activities do not constitute prohibited political activity. However, certain other so--called voter education activities may violate the ban on political activities. In 1978 the IRS evaluated four voter education activities. ⁹³ The relevant portion of the ruling is set forth below:

Situation 1

Organization A has been recognized as exempt under section 501(c)(3) of the Code by the Internal Revenue Service. As one of its activities, the organization annually prepares and makes generally available to the public a compilation of voting records of all members of Congress on major legislative issues involving a wide range of subjects. The publication contains no editorial opinion, and its contents and structure do not imply approval or disapproval of any members or their voting records.

The “voter education” activity of Organization A is not prohibited political activity within the meaning of section 501(c)(3) of the Code.

Situation 2

Organization B has been recognized as exempt under section 501(c)(3) of the Code by the Internal Revenue Service. As one of its activities in election years, it sends a questionnaire to all candidates for governor in State M. The questionnaire solicits a brief statement of each candidate's position on a wide variety of issues. All responses are published in a voters guide that it makes generally available to the public. The issues covered are selected by the organization solely on the basis of their importance and interest to the electorate as a whole. Neither the questionnaire nor the voters guide, in content or structure, evidences a bias or preference with respect to the views of any candidate or group of candidates.

The “voter education” activity of Organization B is not prohibited political activity within the meaning of section 501(c)(3) of the Code.

Situation 3

Organization C has been recognized as exempt under section 501(c)(3) of the Code by the Internal Revenue Service. Organization C undertakes a “voter education” activity patterned after that of Organization B in Situation 2. It sends a questionnaire to candidates for major public offices and uses the responses to prepare a voters guide which is distributed during an election campaign. Some questions evidence a bias on certain issues. By using a questionnaire structured in this way, Organization C is participating in a political campaign in contravention of the provisions of section 501(c)(3) and is disqualified as exempt under that section.

Situation 4

Organization D has been recognized as exempt under section 501(c)(3) of the Code. It is primarily concerned with land conservation matters. The organization publishes a voters guide for its members and others concerned with land conservation issues. The guide is intended as a compilation of incumbents' voting records on selected land conservation issues of importance to the organization and is factual in nature. It contains no express statements in support of or in opposition to any candidate. The guide is widely distributed among the electorate during an election campaign. While the guide may provide the voting public with useful information, its emphasis on one concern indicates that its purpose is not nonpartisan voter education.

By concentrating on a narrow range of issues in the voters guide and widely distributing it among the electorate during a election campaign, Organization D is participating in a political campaign in contravention of the provisions of section 501(c)(3) and is disqualified as exempt under that section.

This ruling was amplified by the IRS in 1980 in Revenue Ruling 80--282. An exempt organization engaged in various charitable and educational activities, maintained an office that monitored and reported on judicial and legislative activities and developments, and distributed a monthly newsletter to some 2,000 interested persons nationwide. The monthly newsletter contained expressions of the organization's views on a broad range of legislative and judicial issues, and occasionally encouraged readers to contact governmental officials to support or oppose specific action. Following each session of Congress, the organization published a summary of the voting records of all incumbent members of Congress on selected legislative issues important to it, together with an expression of the organization's position on those issues. Each incumbent's votes were reported in a way that illustrated whether he or she voted in accordance with the organization's position on each issue. However, the newsletter was politically nonpartisan, and contained no reference to any political campaigns, candidates, or statements endorsing or rejecting any incumbent as a candidate for public office. Further, no mention was made of an individual's overall qualification for public office, nor was there any comparison with candidates that might be competing with the incumbents in future political campaigns. Publication of voting records usually occurred after the adjournment of a particular session of Congress and was not geared to the conduct of any particular election. Under these circumstances, the IRS ruled that the organization had not engaged in prohibited political activity:

[T]he format and content of the publication are not neutral, since the organization reports each incumbent's votes and its own views on selected legislative issues and indicates whether the incumbent supported or opposed the organization's view. On the other hand, the voting records of all incumbents will be presented, candidates for reelection will not be identified, no comment will be made on an individual's overall qualifications for public office, no statements expressly or impliedly endorsing or rejecting any candidate for public office will be offered, no comparison of incumbents with other candidates will be made, and the organization will point out the inherent limitations of judging the qualifications of an incumbent on the basis of certain selected votes by stating the need to consider such unrecorded matters as performance on subcommittees and constituent advice.

In view of the foregoing, other factors must be examined to determine whether in the final analysis the organization is participating or intervening in a political campaign.

In the instant case, the organization will not widely distribute its compilation of incumbents' voting records. The publication will be distributed to the organization's normal readership who number only a few thousand nationwide. This will result in a very small distribution in any particular state or congressional district. No attempt will be made to target the publication toward particular areas in which elections are occurring nor to time the date of publication to coincide with an election campaign.

In view of these facts, Situations 3 and 4 of Revenue Ruling 78--248 [quoted above] are distinguishable from the present case, and the organization will not be considered to be engaged in prohibited political campaign activity.

In another illuminating ruling, the IRS held in 1974 that an exempt section 501(c)(3) organization that operated a broadcasting station presenting religious, educational, and public interest programs, was not participating in political campaigns on behalf of candidates for public office by providing reasonable air time equally available to all legally qualified candidates for election to public office and by endorsing no candidate or viewpoint.⁹⁴ The IRS observed that

the provision of broadcasting facilities to bona fide legally qualified candidates for elective public office . . . furthered the education of the electorate by providing a public forum for the exchange of ideas and the debate of public issues which instructs them on subjects useful to the individual and beneficial to the community. . . . . The fact that the organization makes its facilities equally available to the candidates for public office does not make the expression of political views by the candidates the acts of the broadcasting station within the intendment of section 501(c)(3) of the Code.

The IRS also emphasized that before and after each broadcast the organization stated that the views expressed were those of the candidate and not the station, that the station endorsed no candidate or viewpoint, that the presentation was made as a public service to educate the electorate, and that equal opportunity would be presented to all bona fide legally qualified candidates for the same public office to present their views.

In another ruling, the IRS revoked a religious organization's tax--exempt status because of its political activities.⁹⁵ The organization was established for religious and charitable purposes, including the protection of (1) religious liberty, (2) the rights of unborn children, and (3) the rights of parents to raise their children without government interference. The organization encouraged members to run for local political office, and it published a “voters survey” presenting the views of presidential and vice--presidential candidates on abortion, homosexuality, school prayer, secular humanism, and the “equal rights amendment.” The survey also reported the positions of state political candidates on a variety of issues including the state income tax, parents' rights, abortion, the equal rights amendment, homosexual rights, church school freedom, evolution, state lotteries, and prostitution. The survey disclaimed any attempt to judge a candidate's private morality, or to “rate” or endorse any candidate. The stated purpose of the surveys was to present the candidates' positions on family and moral issues. The organization did represent that the survey was designed to “enable Christians to vote intelligently.” The organization also claimed great success in defeating state legislation abridging Christian rights, and announced its legislative agenda for the following year. It contacted legislators concerning proposed legislation, and urged members to do the same. Nearly 76 percent of its total budget was spent on legislative activities.

The IRS “General Counsel's Office” ruled that the organization's tax--exempt status would have to be revoked on the basis of its political activities. It began its opinion by noting that section 501(c)(3) of the Internal Revenue Code (under which churches and many religious organizations are exempt) requires that an exempt organization not participate or intervene in any political campaign on behalf of (or in opposition to) any candidate for public office. The IRS concluded that the organization violated this requirement. It observed:

The [organization's] officers, directors, employees and members are united in their belief that “God wants Christians to assume civil authority.” The organization pursued two complementary strategies to achieve this objective—voters surveys and election of [local politicians]. In the short term, the [organization] encouraged its members to “vote intelligently” for righteous or Christian candidates in the primary and general elections. The voters surveys clearly identified Christian candidates by their positions on the issues. The [organization] also strove to identify righteous candidates in order to publicize such candidates, presumably through future voters surveys or other means. The organization also advocated that Christians dominate the political parties so that more Christian candidates would be nominated and elected to public office. The first step in the [organization's] long--term strategy was to encourage members to be elected as precinct committeemen. These individuals could then exert influence within the party apparatus . . . .

The IRS went on to provide important clarification as to the meaning of “participation” or “intervention” in political campaigns. The IRS observed:

Organizations intervene in political campaigns in diverse ways. The traditional, direct approach is to criticize or praise candidates running in the general election. At earlier stages in the elective process, an organization may intervene in a primary election or dispatch members to influence the selection of candidates at party caucuses or conventions. The [organization] sought, through its advocacy in its publications, to build a cadre of precinct committeemen in order to further its ultimate objective: the nomination and election of candidates who shared the [organization's] beliefs. Intervention at this early stage in the elective process is, we believe, sufficient to constitute intervention in a political campaign.

The IRS noted that there was some doubt as to whether precinct committeemen were candidates for public office, but it concluded that they were. It also conceded that the organization could allege that it merely educated its members on civics and government and therefore was furthering its exempt purposes. However, it rejected such a view on the basis of all the facts. This ruling represents the view of the IRS national office, and it should be carefully considered by any church or religious organization contemplating similar activities.

What conclusions can be reasonably drawn from the legal precedent summarized above? Consider the following:

1. A church or other organization exempt from federal income taxation under section 501(c)(3) of the Code may not “participate in, or intervene in (including the publishing or distributing of statements), any political campaign on behalf of any candidate for public office.” This is an absolute prohibition—there is no requirement that the participation or intervention be “substantial.” The problem is in defining “participation” or “intervention.” For example, does a minister's endorsement of (or opposition to) a particular candidate while speaking from the church pulpit constitute participation or intervention by the church in a political campaign? The argument could be made that the minister, while speaking from the pulpit, is acting in his or her capacity as an “agent” of the church, and accordingly all such statements are attributable to the church. On the other hand, it could also be argued that even if a minister is viewed as an “agent” of a church, an agent generally can only perform those acts and duties that have been authorized by the principal (i.e., employer). Unauthorized statements, contracts, and transactions ordinarily are not attributable to the principal absent its ratification. Thus, unless a minister is expressly authorized by a church to endorse a political candidate, the argument could be made that any endorsement of a candidate by the minister is unauthorized and not attributable to the church without its ratification. Unfortunately, existing legal precedent is of no value in predicting which of these approaches would be accepted by the IRS or the courts. All that can be said is that it is possible that a minister's statements from the pulpit (or in any other official capacity) might be attributable to his or her employing church on the basis of agency. Ministers who wish to make political endorsements despite this risk should at least qualify their remarks by explicitly stating that they are speaking solely in a private capacity and not as an agent of the church, and that the church has taken no action to endorse or express its opposition to any candidate.

2. Even if a minister is deemed to be an agent of the church with respect to statements made from the pulpit, the argument could be made that the endorsement of a candidate from the pulpit of a church does not necessarily constitute participation or intervention in a political campaign. For example, does the endorsement of a presidential candidate by the minister in a church service at which 75 persons are present constitute participation or intervention in a national political campaign? Possibly. But the argument certainly could be made that this endorsement is so minimal in its impact that it cannot reasonably be characterized as participation or intervention in a political campaign. Of course, endorsing a candidate for a local office would be a different matter, since the potential impact would be greatly magnified no matter how small the church's membership. Again, there has been no official recognition of this principle by the IRS or the courts, but it is perhaps one reason why no church has ever had its tax--exempt status questioned on the basis of political activity.

3. In assessing risk, clergy should be aware of the fact that not one church has ever lost its tax--exempt status for participating or intervening in political campaigns, despite numerous flagrant violations. This fact should not be viewed as a license to intervene in political campaigns. Much pressure is being applied on the IRS to begin enforcing the limitation on political activities by tax--exempt organizations.

4. The Supreme Court's ruling in First National Bank of Boston v. Belloti⁹⁶ seems to preclude a broad interpretation of the ban on political activities. The Court observed that “if a legislature may direct business corporations to `stick to business,' it also may limit other corporations—religious, charitable, or civic—to their respective `business' when addressing the public. Such power in government to channel the expression of views is unacceptable under the First Amendment.”

5. It is reasonably certain, based on Revenue Ruling 74--574, that a church is free to have political candidates address the congregation, as long as (1) overt campaign activities (enlisting campaign volunteers, etc.) are avoided, (2) the same opportunity is afforded all other qualified candidates, and (3) the congregation is informed before or after the speech that the church does not endorse any candidate for public office. The IRS observed, in Revenue Ruling 74--574, that “the provision of broadcasting facilities to bona fide legally qualified candidates for elective public office . . . furthered the education of the electorate by providing a public forum for the exchange of ideas and the debate of public issues which instructs them on subjects useful to the individual and beneficial to the community. . . . . The fact that the organization makes it facilities equally available to the candidates for public office does not make the expression of political views by the candidates the acts of the broadcasting station within the intendment of section 501(c)(3) of the Code.”

6. Some “voter education” activities will not jeopardize a church's tax--exempt status. However, such activities must be neutral in content and format. Revenue Ruling 80--282 (discussed above) provides a more liberal view of allowable voter education activities in the context of limited circulation or distribution activities.

In conclusion, it is regrettable that the limitations on political activities by churches are so uncertain. This section has attempted to provide as much clarification as is possible so that churches can recognize the risks involved and make informed judgments regarding the nature and extent of their political activities.

b. Basis for the Exemption

Is the exemption of churches and other religious organizations from federal income taxation mandated by the first amendment or is it merely a matter of legislative grace? This is a question that has eluded a definitive answer.⁹⁷ Several courts have held that religious organizations have no constitutional right to be exempted from federal income taxes. For example, one federal court has held that “tax exemption is a privilege, a matter of grace rather than right,”⁹⁸ and another federal court has observed:

We believe it is constitutionally permissible to tax the income of religious organizations. In fact there are those who contend that the failure to tax such organizations violates the no establishment clause of the First Amendment. Since the government may constitutionally tax the income of religious organizations, it follows that the government may decide not to exercise this power and grant reasonable exemptions to qualifying organizations, while continuing to tax those who fail to meet these qualifications. The receiving of an exemption is thus a matter of legislative grace and not a constitutional right.⁹⁹

It is nevertheless true that for as long as federal income taxes have had any potential impact on churches, religious organizations have been expressly exempted from such taxes.¹⁰⁰ Significantly, the exemption of churches is automatic. Unlike other charities, churches are not required to apply for and receive IRS recognition of tax--exempt status.¹⁰¹ This of course assumes that the church satisfies the conditions enumerated in section 501(c)(3) of the Internal Revenue Code. Whether this legislative history indicates a congressional determination that tax exemption of churches is constitutionally mandated is unclear. As noted previously in this chapter, churches and other religious organizations that engage in substantial efforts to influence legislation, that intervene in political campaigns, that are not operated exclusively for religious purposes, that are not organized exclusively for religious purposes, or the net earnings of which inures to the benefit of a private individual are not entitled to exemption. Further, in 1969 Congress elected to tax the “unrelated business income” of all religious organizations including churches.¹⁰² Certainly such factors militate against the conclusion that religious organizations are constitutionally immune from taxation.

The United States Supreme Court, in upholding the constitutionality of state property tax exemptions for properties used solely for religious worship, suggested that a constitutional basis may exist for property tax exemptions.¹⁰³ The Court emphasized that the first amendment forbids the government from following a course of action, be it taxation of churches or exemption, that results in an excessive governmental entanglement with religion. The Court reasoned that eliminating the tax exemption of properties used exclusively for religious worship would be unconstitutional since it would expand governmental entanglement with religion: “Elimination of exemption would tend to expand the involvement of government by giving rise to tax valuation of church property, tax liens, tax foreclosures, and the direct confrontations and conflicts that follow in the train of those legal processes.”¹⁰⁴

The Court observed that “exemption creates only a minimal and remote involvement between church and state and far less than taxation of churches” and that “[t]he hazards of churches supporting government are hardly less in their potential than the hazards of government supporting churches.” The Court concluded that the grant of a tax exemption is not an impermissible “sponsorship” of religion since “the government does not transfer part of its revenue to churches but simply abstains from demanding that the church support the state.” Such reasoning suggests that the exemption of religious organizations from federal income taxation may be rooted in part in the United States Constitution, at least to the extent that it can be demonstrated that the taxation of religious organizations would lead to substantial governmental entanglement with religion far greater than the entanglement occasioned by exemption.¹⁰⁵

On the other hand, the Supreme Court ruled unanimously in 1990 that the State of California could tax the sale of religious literature by Jimmy Swaggart Ministries, a religious organization organized “for the purpose of establishing and maintaining an evangelistic outreach for the worship of Almighty God . . . by all available means, both at home and in foreign lands,” including evangelistic crusades, missionary endeavors, radio broadcasting, television broadcasting, and publishing.¹⁰⁶ In 1982, the Court ruled that the first amendment guaranty of religious freedom was not violated by requiring Amish employers to withhold social security taxes from their employees' wages.¹⁰⁷ The Court acknowledged that subjecting Amish employers to compulsory withholding of social security taxes violated their religious convictions. However, the Court concluded that this interference with religious convictions was outweighed by an “overriding governmental interest”:

Because the social security system is nationwide, the governmental interest is apparent. The social security system in the United States serves the public interest by providing a comprehensive insurance system with a variety of benefits available to all participants, with costs shared by employers and employees. The social security system is by far the largest domestic governmental program in the United States today, distributing approximately $11 billion monthly to 36 million Americans. The design of the system requires support by mandatory contributions from covered employers and employees. This mandatory participation is indispensable to the fiscal vitality of the social security system. . . . Moreover, a comprehensive national social security system providing for voluntary participation would be almost a contradiction in terms and difficult, if not impossible, to administer. Thus, the Government's interest in assuring mandatory and continuous participation in and contribution to the social security system is very high.¹⁰⁸

The Court concluded that “[b]ecause the broad public interest in maintaining a sound tax system is of such a high order, religious belief in conflict with the payment of taxes affords no basis for resisting the tax.” This language would appear to diminish the availability of a constitutionally--mandated exemption of churches from federal income taxation.

The exemption of religious organizations from federal income taxation does not constitute an impermissible “establishment of religion” in violation of the first amendment.¹⁰⁹ The United States Supreme Court has observed that “[t]here is no genuine nexus between tax exemption and establishment of religion.”¹¹⁰

c. Recognition of Exemption

(1) General Principles

Before 1969 the statutory requirement that an organization file a notice or application with the IRS in order to be exempt was nonexistent. An organization was automatically exempt if it met the requirements of section 501(c)(3) of the Internal Revenue Code. Although many organizations applied for recognition of exemption by filing a Form 1023 (Application for Recognition of Exemption Under Section 501(c)(3) of the Internal Revenue Code),¹¹¹ some did not.

The Tax Reform Act of 1969 added section 508 to the Internal Revenue Code. This section stipulated that after October 9, 1969, no organization, with a few exceptions (noted below), would be treated as exempt unless it gave notice to the IRS, in the manner prescribed by regulation, that it was applying for recognition of exempt status under section 501(c)(3). This is commonly referred to as the “508(a) notice.” The income tax regulations state that notice is given by submitting a properly completed Form 1023 to the appropriate IRS district director.¹¹² The regulations further state that the notice must be filed within 15 months of the end of the month in which the organization was organized. Organizations that were in existence on October 9, 1969, were required to file the notice with the appropriate IRS district director by March 22, 1973. The regulations allow for extensions of time for filing the notice when a reasonable basis exists.¹¹³ If an organization files its Form 1023 after the 15--month period it may be recognized as exempt only from the date its application was filed.¹¹⁴ It follows that the organization would be a taxable organization under such circumstances and thus would be unable to receive deductible contributions for the period preceding the date the application was filed. The 15--month rule does not apply to “churches, interchurch organizations of local units of a church, conventions or associations of churches, or integrated auxiliaries of a church, such as a men's or women's organization, religious school, mission society, or youth group.”¹¹⁵

Since an “incomplete” application does not constitute notice under section 508(a), the distinction between such an application and a completed application is important. The IRS recognizes that cases will arise when the requirements of a completed application are met but additional information is needed for a determination of exempt status. In such cases the notice requirement of section 508(a) is considered to be satisfied whether or not the additional information is timely received. On the other hand, the IRS has stated that the absence of any of the following materials will cause an application to be regarded as incomplete: an authorized signature; an employer identification number; a statement of receipts and expenditures and a balance sheet for the current year and the three preceding years or the years the organization has been in existence if less than four years; a statement of proposed activities and a description of anticipated receipts and contemplated expenditures; a copy of the organization's “organizing document” signed by a principal officer; and a copy of the organization's bylaws.¹¹⁶ If information submitted in the application is incomplete and the organization supplies the necessary additional information requested by the IRS within the additional time stipulated in the request, the application will be considered timely filed.¹¹⁷

An application for recognition of exemption is considered by the “key district director”¹¹⁸ who either refers the case to the IRS National Office for advice or a ruling, issues a favorable determination letter recognizing an organization's exempt status, or issues a proposed adverse determination letter denying exempt status. Exempt status can be recognized in advance of actual operations if proposed operations can be described in sufficient detail to permit a conclusion that the organization will clearly meet the requirements of section 501(c)(3). A mere restatement of purposes or a statement that the proposed activities will be in furtherance of such purposes will not satisfy this requirement.

Section 508(c) and the income tax regulations state that the following organizations are exempt from the section 508(a) notice requirements and therefore are not required to file a Form 1023 to be exempt from federal income tax or to receive tax deductible contributions:

(a) Churches, interchurch organizations of local units of a church, conventions or associations of churches, or integrated auxiliaries of a church, such as a men's or women's organization, religious school, mission society, or youth group;

(b) Any organization which is not a private foundation . . . and the gross receipts of which in each taxable year are normally not more than $5,000 . . .

(c) Subordinate organizations (other than private foundations) covered by a group exemption letter . . . .¹¹⁹

The recognition of the exempt status of such organizations without the need for complying with the section 508(a) notice requirements of course assumes that all of the prerequisites contained in section 501(c)(3) of the Code have been satisfied.¹²⁰

The IRS maintains that although such organizations are not required to file a Form 1023 to be exempt from federal income tax or to receive tax deductible contributions, they may “find it advantageous to obtain recognition of exemption.”¹²¹ Presumably, such organizations might voluntarily wish to obtain IRS recognition of tax--exempt status in order to assure contributors that donations will be tax deductible. The IRS publishes a cumulative listing (Publication 78) of organizations that have been determined to be exempt from federal income tax, contributions to which are tax deductible.¹²² Contributions made to an organization whose name does not appear in Publication 78 may be questioned by the IRS, in which case the contributor would have to substantiate the deductibility of his or her contribution by demonstrating that the donee met the requirements of section 501(c)(3) and was exempt from the notice requirements. Similarly, some potential contributors may be reluctant to contribute to a religious organization not listed in Publication 78. Churches and religious denominations should be aware that their applications for exemption from federal income taxation (Form 1023) and related materials are now subject to public inspection.¹²³

Although the vast majority of applications for recognition of tax--exempt status are approved by the IRS, some result in adverse determinations. If the IRS issues an adverse determination letter, it must advise the organization of its right to protest the determination by requesting consideration by an IRS Appeals Office. To do this, the organization must submit to the appropriate district director within 30 days from the date of the adverse letter a statement of the facts, law, and arguments in support of its position.¹²⁴ If the Appeals Office upholds the adverse determination, the organization may file a suit for a declaratory judgment in federal court.¹²⁵ The declaratory judgment remedy cannot be used unless either all remedies within the IRS have been exhausted or 270 days have elapsed since the organization requested a determination and the organization has taken in a timely manner all reasonable steps to secure such a determination.

(2) Group Exemptions

Recognition of exemption from federal income tax under section 501(c)(3) of the Internal Revenue Code may be obtained on a group basis for “subordinate organizations” affiliated with and under the supervision or control of a “central organization.”¹²⁶ This procedure relieves each of the subordinates covered by a group exemption letter of the necessity of filing its own application for recognition of exemption. To be eligible for a group exemption ruling, a central organization must obtain recognition of its own exempt status. It must also submit the following information on behalf of those subordinates to be included in the group exemption letter:

1. A letter signed by a principal officer of the central organization setting forth or including as attachments the following:

a. information verifying that the subordinates to be included in the group exemption letter are affiliated with the central organization; are subject to its general supervision or control; are all eligible to qualify for exemption under the same paragraph of section 501(c) of the Code, though not necessarily the paragraph under which the central organization is exempt; are not private foundations; and are organizations that have been formed within the 15--month period prior to the date of submission of the group exemption application if they are claiming section 501(c)(3) status and are subject to the notice requirements of section 508(a)¹²⁷

b. a detailed description of the purposes and activities of the subordinates including the source of receipts and the nature of expenditures

c. a sample copy of a uniform governing instrument (such as a charter or articles of association) adopted by the subordinates, or in its absence, copies of representative instruments

d. an affirmation to the effect that, to the best of the officer's knowledge, the purposes and activities of the subordinates are as stated

e. a statement that each subordinate to be included in the group exemption letter has furnished written authorization to that effect, signed by a duly authorized officer of the subordinate, to the central organization

f. a list of subordinates to be included in the group exemption letter to which the IRS has already issued an outstanding ruling or determination letter relating to exemption

g. if the application for a group exemption letter involves section 501(c)(3) of the Code and is subject to the provisions of the Code requiring that the central organization give timely notice that it is not a private foundation, an affirmation to the effect that, to the best of the officer's knowledge and belief, no subordinate to be included in the group exemption letter is a private foundation

h. for each subordinate that is a school, the information required by Revenue Ruling 71--447 and Revenue Procedure 75--50 relating to proof of nondiscrimination

2. A list of the names, mailing addresses, actual addresses, and employer identification numbers of subordinates to be included in the group exemption letter. A current directory of subordinates may be furnished in lieu of the list if it includes the required information and if the subordinates not to be included in the group exemption letter are identified.

If the central organization does not have an employer identification number for a subordinate unit, it must submit a completed application (Form SS--4) for such a number with its group exemption application.

An incorporated subordinate unit of a central organization may be included in a group exemption letter if the central organization submits evidence to show that it maintains adequate control over the incorporated subordinate unit, and that the subordinate is otherwise qualified. However, a subordinate that is organized and operated in a foreign country may not be included in a group exemption letter.

A new organization that wishes to be included in a group exemption letter must submit its authorization to the central organization before the end of the fifteenth month after it was formed in order to satisfy the section 508(a) notice requirements.¹²⁸ The central organization also must include all new subordinates in its next annual submission of information. Failure to comply with these requirements will result in the denial of a group ruling request.¹²⁷

To maintain a group exemption letter, the central organization must submit the following information to the appropriate IRS center each year within 90 days before the close of its annual accounting period: (1) information regarding all changes in the purposes, character, or method of operation of the subordinates included in the group exemption letter; (2) a separate list including names, addresses, and employer identification numbers of subordinates that have changed their names or addresses during the year, that no longer are to be included in the group exemption letter because they have ceased to exist, disaffiliated, or withdrawn their authorization to the central organization, or that are to be added to the group exemption letter because they are newly organized or affiliated or because they have recently authorized the central organization to include them; and (3) the information required of a central organization on behalf of subordinates to be added to the group exemption letter.

The continued effectiveness of a group exemption letter is based on the following conditions: (1) the continued existence of the central organization, (2) the continued qualification of the central organization for exemption under section 501(c)(3) of the Code, (3) the submission by the central organization of the information required annually, and (4) the annual filing of an information return (Form 990) by the central organization if such a return is required.

The group exemption procedure technically is available only to “connectional,” or hierarchical, church organizations consisting of a “central organization” that exerts “general supervision or control” over “subordinate” local churches and church agencies. There are many conventions and associations of churches, however, that exert little if any “general supervision or control” over “subordinate” churches. Up until now, these “congregational” conventions and associations of churches have had to construe the group exemption requirements very loosely in order to obtain the benefits of a group exemption. Many have done so. A potential problem with such an approach is that the association or convention of churches itself may increase its potential liability for the misconduct and improprieties of affiliated churches and church agencies, since in pursuing the group exemption the association or convention must affirm that it does in fact exercise “general supervision or control” over its affiliates. Such an affirmation could serve as a possible basis of legal liability unless the association or convention could demonstrate that it pursued the group exemption as a matter of expedience and that it construed the “supervision or control” language very loosely. It also would be relevant to indicate that congregational associations and conventions of churches are forced to interpret the “control” language loosely because of the discrimination by the IRS against such organizations in favor of connectional, or hierarchical, church organizations. In the final analysis, substance ordinarily takes priority over form or language.

The current group exemption procedure, granting favored status only to connectional church organizations, is suspect under the Supreme Court's interpretation of the first amendment's nonestablishment of religion clause. In 1982, the Court invalidated a Minnesota law that imposed certain registration and reporting requirements upon religious organizations soliciting more than 50 percent of their funds from nonmembers.¹²⁸ The Court observed that “when we are presented with a state law granting a denominational preference, our precedents demand that we treat the law as suspect and that we apply strict scrutiny in adjudging its constitutionality.” The Court concluded that any law granting a denominational preference must be “invalidated unless it is justified by a compelling governmental interest, and unless it is closely fitted to further that interest.”

Similarly, a federal appeals court, in construing section 6033 of the Internal Revenue Code, observed: “[I]f `church' were construed as meaning only hierarchical churches such as the Catholic Church—[this] would result in an unconstitutional construction of the statute [IRC 6033] because favorable tax treatment would be accorded to hierarchical churches while being denied to congregational churches, in violation of the first amendment.”¹²⁹

There is no conceivable governmental interest that would justify the government's stated preference for connectional church organizations in the present group exemption procedure. And even if such an interest were assumed, the government has not used the least restrictive means of effecting it.

d. Notifying the IRS of Changes in Character, Purposes, or Operation

The income tax regulations specify that an organization that has been determined by the IRS to be exempt may rely upon such determination “so long as there are no substantial changes in the organization's character, purposes, or methods of operation. Accordingly, all exempt organizations are under a duty to notify the IRS of any substantial changes in character, purposes, or methods of operation.

e. Annual Information Return Requirements

Most organizations exempt from federal income tax must file an annual information return with the IRS on Form 990. Form 990 is a 9--part form containing 105 lines. In general, Form 990 requests information regarding an exempt organization's income, disbursements, assets, liabilities, services, officers and directors, and income--producing activities.¹³¹ The following organizations, among others, are specifically exempted from this requirement:

(i) A church, an interchurch organization of local units of a church, a convention or association of churches, or an integrated auxiliary of a church;¹³²

(ii) An exclusively religious activity of any religious order;

(iii) An organization (other than a private foundation) the gross receipts of which in each taxable year are normally not more than $5,000 . . .¹³³

(iv) A mission society sponsored by or affiliated with one or more churches or church denominations, more than one--half of the activities of which society are conducted in, or directed at persons in, foreign countries;

. . . .

(vii) An educational organization (below college level) which is described in section 170(b)(A)(ii), which has a program of a general academic nature, and which is affiliated . . . with a church or operated by a religious order.¹³⁴

A tax--exempt organization that is required to file a 990 form is subject to a penalty of $10 a day for each day the failure continues. The same penalty applies if the organization fails to give correct and complete information on its return. The maximum penalty for any one return is the lesser of $5,000 or 5 percent of the organization's gross receipts for the year. No penalty will be imposed if reasonable cause for failure to file a timely form can be shown.

f. Loss of Exemption

An exemption ruling or determination letter may be revoked or modified by a ruling or determination letter addressed to the organization or by a revenue ruling or other statement published in the Internal Revenue Bulletin. The revocation or modification may be retroactive if the organization omitted or misstated a material fact or operated in a manner materially different from that originally represented.¹³⁵ In any event, revocation or modification ordinarily will take effect no earlier than the time at which the organization received written notice that its exemption ruling or determination letter might be revoked or modified.

Loss of a church's exempt status would have a variety of negative consequences, including (1) the church's net income would be subject to federal (and possibly state) income taxation; (2) donors no longer could deduct contributions to the church; (3) ineligibility to establish “403(b)” tax--sheltered annuities; (4) possible loss of property and sales tax exemptions; (5) loss of preferential mailing rates; and (6) possible loss of state and federal unemployment tax exemptions. Clearly, any activity that jeopardizes a church's exemption from federal income taxation is a matter that must be taken very seriously.

g. Consequences of Exemption

The IRS lists the following “collateral benefits” of exemption from federal income taxes:¹³⁶

1. In addition to the exemption from the payment of federal income tax, organizations recognized as exempt under section 501(c)(3) may enjoy collateral tax exemption under some state and local income, property, sales, use, or other forms of taxation.

2. Contributions to organizations recognized as exempt under section 501(c)(3) are deductible as charitable contributions on the individual or corporate donor's federal income tax return.

3. Services performed for an organization described in section 501(c)(3) may be exempt from unemployment taxes and certain excise taxes.

4. Religious organizations are among those listed under United States Postal Service regulations as being eligible to mail at preferred postal rates. The regulations state that exemption from federal income taxes will be considered as evidence of qualification for preferred postal rates but will not be controlling.

5. Organizations recognized as exempt under section 501(c)(3) are able to offer employees the benefit of special taxation of annuity provisions under section 403(b) of the Code.

h. Mail Order Churches

In recent years, many taxpayers have attempted to exclude all or part of their income from federal taxation through the creation of a mail order church. The IRS Exempt Organizations Handbook addresses the subject of mail order churches as follows:

The term “mail order church” refers to organizations set up pursuant to “church charters” purchased through the mail from organizations that claim that the charters and other “ministerial credentials” can be used to reduce or eliminate an individual's federal income tax liability. Organizations selling these documents represent that an individual can form a tax--exempt church by purchasing a “church charter.” The individual, who controls the purported church, and determines how its money will be spent, then contributes up to 50 percent of his or her income to the “church,” claiming a charitable contribution deduction . . . . Alternatively, the individual may take a “vow of poverty,” under which the individual's assets and income are transferred to the church. The individual then claims that his or her income is not includable in gross income for federal tax purposes nor subject to employment taxes or income tax withholding. Under either of these alternatives, the assets and income transferred to the church are in turn used to pay the personal living expenses of the founder.¹³⁷

The IRS has challenged the tax--exempt status of several mail order churches on the ground that they fail to meet one or more of the six prerequisites of exempt status discussed earlier in this chapter. The IRS often asserts that mail order churches are ineligible for tax--exempt status since they are not organized or operated exclusively for exempt purposes. This assertion often is based upon section 1.501(c)(3)--1(d)(1)(ii) of the income tax regulations, which specifies that

[a]n organization is not organized or operated exclusively for one or more [exempt purposes] unless it serves a public rather than a private interest. Thus, to meet [this] requirement . . . it is necessary for an organization to establish that it is not organized or operated for the benefit of private interests such as designated individuals, the creator or his family, shareholders of the organization, or persons controlled, directly or indirectly, by such private interests.

Accordingly, if a church exists primarily to serve the private interests of its creator, it is not serving a public interest and therefore is not organized or operated for exempt purposes. Such a finding will be made whenever a church exists primarily as a vehicle for handling the personal financial transactions of its founder.

To illustrate, in Revenue Ruling 81--94,¹³⁸ the IRS denied exempt status to a mail order church founded by a nurse. Following a vow of poverty, the nurse had transferred all of her assets, including her home and automobile, to her church and assigned her secular income to the church's checking account. In return, all of her expenses, such as her home mortgage and all outstanding credit card balances, were assumed by the church. The nurse also was provided with a full living allowance sufficient to maintain her previous standard of living. The church permitted her to use the home and automobile for personal uses. While the church's charter stated that it was organized exclusively for religious and charitable purposes, including a religious mission of healing the spirit, mind, emotions, and body, the church conducted few if any religious services and performed virtually no religious functions. The IRS concluded that the church existed primarily as a vehicle for handling the nurse's personal financial transactions and thus it was operated for the private interests of a designated individual rather than for a public interest.¹³⁹

The IRS often asserts that a mail order church is ineligible for exempt status since its net earnings inure to the benefit of private individuals. As noted earlier in this chapter, a church cannot be exempt from federal income taxes if any part of its net earnings inures to the benefit of a private individual (other than as reasonable compensation for services rendered). Prohibited inurement may be indicated by one or more of the following circumstances: (1) compensation paid by an exempt organization is excessive in light of services rendered, (2) the value of services performed and of the corresponding compensation paid cannot be established objectively, (3) payments are not compensation for services rendered, (4) material benefits are provided in addition to regular wages, (5) compensation is based on a percentage of a church's gross receipts, (6) substantially all of a church's gross receipts come from its minister and are returned to him or her in the form of compensation and reimbursement of personal expenses, or (7) a church exists primarily to facilitate the personal financial transactions of its founder.

To illustrate, inurement has been found in the following contexts: church ministers received fees, commissions, royalties, loans, a personal residence, and a car, in addition to ordinary wages;¹⁴⁰ a church devised a formula for determining the percentage of its gross receipts that would be payable to its minister, under which formula the minister received 63 percent of the church's gross receipts in one year and 53 percent in the next;¹⁴¹ a boilermaker was ordained and chartered as “a church personally” by a mail order organization, took a vow of poverty, continued to work full time in secular employment, assigned his salary to his church account over which he maintained complete control, paid all of his personal expenses out of the church account, and claimed the maximum charitable contribution deduction for the amounts he transferred to the church account;¹⁴² a married couple was ordained by and received a church charter from a mail order organization, established a church in their home, conducted religious services for between 3 and 10 persons, paid all of their secular income to the church, and received such income back in the form of compensation and a housing allowance;¹⁴³ a married couple took a vow of poverty and established a religious order in which they and their children were the only members, assigned all of their secular income to the order, and claimed a charitable contribution deduction for the income assigned;¹⁴⁴ a taxpayer was ordained by and received a church charter from a mail order organization, established a church in his home, declared himself and two others to be its ministers, assigned all of his secular income to the church, and received substantially all of it back in the form of wages, a housing allowance, loans, and travel allowances;¹⁴⁵ a church made substantial cash grants to its officers without provision for repayment;¹⁴⁶ and a mail order church could not support substantial payments made to its founder.¹⁴⁷

Predictably, standards that are comprehensive enough to deal effectively with the abuses of mail order churches may be sufficiently broad to affect adversely some legitimate churches. For example, the Tax Court denied exempt status to a church having 56 members that conducted regular evangelistic worship services, performed baptisms, communion services, weddings, and burials; whose beliefs included the infallibility of the Bible; and whose pastor testified that “we do not have a creed but Christ; no law but love, no book but the Bible.”¹⁴⁸ The IRS contended that the church was not entitled to exempt status since it had not established that (1) its charter or bylaws provided for the distribution of church property to another exempt organization upon dissolution, (2) it was operated exclusively for religious purposes, (3) it was operated for public rather than private interests, and (4) its net earnings did not inure to the benefit of private individuals. In another case, the Tax Court observed: “Until recent years, a mere declaration that an organization was a church was almost enough to assure its treatment as such under the revenue laws. The cynical abuse of the church concept for tax purposes in recent years, however, has made necessary the same critical analysis of organizations claiming exemption on that ground as organizations engaged in admittedly secular activities.”¹⁴⁹ Churches, like any other exempt organization, have the burden of proving that they meet each of the prerequisites to exempt status. The burden of proof is not on the IRS to disprove eligibility for exempt status. Many mail order churches have been denied exempt status because they could not prove that they in fact were organized or operated exclusively for exempt purposes or that none of their net earnings inured to the benefit of private individuals.

Many mail order church schemes involve the assignment of a founder's secular income to his church's checking account, and the founder's claiming the largest allowable charitable contribution deduction on his or her federal income tax return. Since a charitable contribution deduction is available only to donors who make contributions to an exempt organization, the deductibility of charitable contributions to mail order churches often is challenged by the IRS. Unless taxpayers can prove that their contributions were made to a church that satisfies the prerequisites to exempt status listed in section 501(c)(3) of the Internal Revenue Code, their deductions will be disallowed. Occasionally, the IRS challenges a charitable contribution to a mail order church on the ground that such a transfer does not constitute a contribution. To illustrate, in Revenue Ruling 78--232,¹⁵⁰ the IRS disallowed a charitable contribution deduction for any part of a taxpayer's secular income that he assigned to his mail order church's checking account, since

[s]ection 170 of the Code provides . . . a deduction for charitable contributions to or for the use of [exempt] organizations . . . . Section 170(c)(2) of the Code provides, in part, that the term “charitable contribution” means a contribution or gift to or for the use of a corporation organized and operated exclusively for religious or other charitable purposes, no part of the net earnings of which inures to the benefit of any private shareholder or individual.

The term “charitable contribution,” as used in section 170 of the Code, has been held to be synonymous with the word “gift.” A gift for purposes of section 170 is a voluntary transfer of money or property that is made with no expectation of procuring a commensurate financial benefit in return for the transfer. It follows that if the benefits the donor can reasonably expect to obtain by making the transfer are sufficiently substantial to provide a quid pro quo for it, then no deduction under section 170 is allowable.

In the instant case the money deposited by the taxpayer in the . . . church account was used or available for use for the taxpayer's benefit. . . . Accordingly, the amount of the salary checks deposited by the taxpayer in the bank account maintained in the name of the . . . church is not deductible as a “charitable contribution” under section 170 of the Code.

The Tax Court has observed that “our tolerance for taxpayers who establish churches solely for tax avoidance purposes is reaching a breaking point. Not only do these taxpayers use the pretext of a church to avoid paying their fair share of taxes, even when their brazen schemes are uncovered many of them resort to the courts in a shameless attempt to vindicate themselves.”¹⁵¹ Similarly, a federal appeals court has lamented that “we can no longer tolerate abuse of the judicial review process by irresponsible taxpayers who press stale and frivolous arguments, without hope of success on the merits, in order to delay or harass the collection of public revenues or for other nonworthy purposes.”¹⁵² The court ordered a mail order church to pay the government's costs and attorneys' fees incurred in contesting the church's claim of exemption, and warned that in the future it would “deal harshly” with frivolous tax appeals involving mail order churches. Other courts have sustained additions to tax for negligence or intentional disregard of tax laws pursuant to section 6653(a) of the Code.¹⁵³

There are many potentially adverse consequences that can befall the founder of a mail order church. These include civil fraud penalties, criminal penalties, sanctions and costs of up to $25,000 for claiming a frivolous position, and substantial understatement penalties.¹⁵⁴ In addition, as part of its Illegal Tax Protester Program, the IRS has developed guidelines to assist its agents in “detecting, processing, examining and investigating” mail order churches.¹⁵⁵ Further, the IRS Internal Revenue Manual instructs agents to

be especially alert to possible fraud when examining organizations identified under the Illegal Tax Protester Program. Fraudulent practices that have been uncovered in such cases include:  

(a) Keeping a double set of books;

(b) Giving of false information/documents to the examining specialist;  

(c) Concealing or destroying financial records; (d) Closing out checking and savings accounts at banks and thereafter conducting financial affairs in cash;

(e) Disguising income from an unrelated trade or business as nontaxable income;

(f) Controlling and using funds in the church bank accounts by the reputed minister for his/her own benefit;

(g) Using funds claimed as contributions to the church for personal use of the reputed minister; and

(h) Falsifying application forms which are signed under penalties of perjury.¹⁵⁶

The IRS is strictly construing the requirements of section 501(c)(3) when assessing the eligibility of a mail order church for exempt status, and it is threatening criminal prosecution of taxpayers who persist in using these tax evasion schemes.

Mail order clergy encounter difficulties in other contexts as well. For example, they have been denied eligibility to conduct marriage ceremonies by some states.¹⁵⁷

i. “Social Welfare” Organizations

Section 501(c)(4) of the Internal Revenue Code exempts nonprofit organizations “operated exclusively for the promotion of social welfare.” The regulations amplify this basis for exemption:

An organization is operated exclusively for the promotion of social welfare if it is primarily engaged in promoting in some way the common good and general welfare of the people of the community. An organization embraced within this section is one which is operated primarily for the purpose of bringing about civic betterments and social improvements.¹⁵⁸

Some religious organizations have applied for tax--exempt status under section 501(c)(4) either because they were unable or unwilling to comply with the more rigorous requirements of section 501(c)(3). The claim ordinarily is made that the organization promotes social welfare because of its religious purposes. This claim, however, has been rejected. To illustrate, one federal court has observed that while “many churches and religious organizations can and do promote the social welfare,” such organizations are not per se a promotion of social welfare since in many cases they benefit their members rather than the general public as a whole.¹⁵⁹ This logic of course ignores the fact that any “social welfare” organizations benefit only small segments of the population.

In 1983, the United States Supreme Court suggested that a section 501(c)(3) organization is free to establish an exempt organization under section 501(c)(4) of the Code as a means of avoiding the limitations on lobbying activities that otherwise would apply.¹⁶⁰

Section 501(c)(4) also exempts “local associations of employees, the membership of which is limited to the employees of a designated person or persons in a particular municipality, and the net earnings of which are devoted exclusively to charitable, educational, or recreational purposes.”

Certainly one of the most valuable benefits of tax--exempt status is the ability to attract tax--deductible contributions. Section 170 of the Internal Revenue Code states in part: “There shall be allowed as a deduction any charitable contribution . . . payment of which is made within the taxable year.” To be deductible, a contribution must meet the following conditions: (1) a gift of cash or other property, (2) made before the close of the tax year for which the contributor is claiming a deduction, (3) unconditional and without material personal benefit to the contributor, (4) made to or for the use of a qualified organization, (5) not in excess of the amount allowed by law, and (6) subject to substantiation. The subject of charitable contributions is discussed fully in chapter 7 of Richard Hammar's Church and Clergy Tax Guide.¹⁶¹

The problem at which the tax on unrelated business income is directed is primarily that of unfair competition. The tax--free status of section [501] organizations enables them to use their profits tax--free to expand operations, while their competitors can expand only with the profits remaining after taxes. In neither the House bill nor your committee's bill does this provision deny the exemption where the organizations are carrying on unrelated active business enterprises, nor require that they dispose of such businesses. Both provisions merely impose the same tax on income derived from an unrelated trade or business as is borne by their competitors. In fact it is not intended that the tax imposed on unrelated business income will have any effect on the tax--exempt status of any organization.¹⁶²

The Revenue Act of 1950 exempted certain organizations from the unrelated business income tax provisions, including churches and conventions or associations of churches. However, it soon became apparent that many of the exempted organizations were engaging, or were apt to engage, in unrelated business. For example, churches were involved in various types of commercial activities, including publishing houses, hotels, factories, radio and television stations, parking lots, newspapers, bakeries, and restaurants. Congress responded in the Tax Reform Act of 1969 by subjecting almost all exempt organizations, including churches and conventions or associations of churches, to the tax on unrelated business income.¹⁶³ Accordingly, for taxable years beginning after December 31, 1969, churches and conventions or associations of churches became subject to the tax on unrelated business income unless the unrelated business was being carried on before May 27, 1969, in which case the tax applies only to years beginning after December 31, 1975.¹⁶⁴

b. Unrelated Business Income

Section 511 of the Code imposes a tax on unrelated business taxable income. Section 512 defines unrelated business taxable income as “the gross income derived by any organization from any unrelated trade or business regularly carried on by it” less certain deductions. Section 513 defines the term unrelated trade or business as

any trade or business the conduct of which is not substantially related (aside from the need of such organization for income or funds or the use it makes of the profits derived) to the exercise or performance by such organization of its charitable, educational, or other purpose or function constituting the basis for its exemption under section 501 . . . .

Accordingly, the following three conditions must be met before an activity of an exempt organization may be classified as an unrelated trade or business and the gross income of such activity subjected to the tax on unrelated business taxable income:

1. the activity must be a trade or business

2. the trade or business must be regularly carried on

3. the trade or business must not be substantially related to exempt purposes

The term trade or business generally includes any activity carried on for the production of income from the sale of goods or performances of services. The term may include such activities as selling goods at a church bazaar, selling commercial advertising in an exempt organization's magazine, and the operation of factories, bingo games, publishing houses, hotels, radio and television stations, grocery stores, restaurants, newspapers, parking lots, record companies, and cleaners. The regulations state that an activity does not lose its identity as a trade or business merely because it is carried on within a larger aggregate of similar activities or within a larger complex of other endeavors which may or may not be related to the exempt purposes of the organization.¹⁶⁵ To illustrate, if a church's parking lot is used by the church as a commercial lot during the week, the fees received are income from an unrelated trade or business even though the lot is necessary for the church's exempt purposes. Similarly, commercial advertising does not lose its identity as a trade or business simply because it is contained in a magazine published by an exempt organization.¹⁶⁶

To be subject to the tax on unrelated business income, an activity constituting a trade or business must be regularly carried on. The regulations specify that in determining whether a trade or business is regularly carried on, regard must be had to the “frequency and continuity with which the activities . . . are conducted and the manner in which they are pursued.”¹⁶⁷ The regulations further stipulate that this requirement must be applied in light of the purpose of the unrelated business income tax to place the business activities of exempt organizations on the same tax basis as the taxable business endeavors with which they compete.¹⁶⁸ If a particular income--producing activity is of a kind normally conducted by taxable commercial organizations on a year--round basis, the conduct of such activities by an exempt organization over a period of only a few weeks does not constitute the regular carrying on of a trade or business. For example, the operation of a sandwich stand by a church for only one or two weeks at a county fair is not “regularly carried on” since such a stand would not compete with a similar facility of a commercial organization that ordinarily would operate on a year--round basis. On the other hand, if a particular income--producing activity is of a type that is ordinarily conducted on a seasonable basis by commercial organizations, then a similar activity conducted by a church for a substantial part of the season would be regularly carried on. The IRS maintains that an activity carried on one day a week on a year--round basis, such as the use of a church parking lot for commercial parking every Saturday, is regularly carried on.¹⁶⁹ However, the income tax regulations specify that certain intermittent income--producing activities occur so infrequently that they will not be regarded as a trade or business regularly carried on.¹⁷⁰ For example, an income--producing activity lasting for a short period of time and conducted on an annual basis will not be considered regularly carried on.¹⁷¹

Finally, to be exempt from the tax on unrelated business income, an activity constituting a trade or business must be substantially related to exempt purposes. The income tax regulations specify that for the conduct of a trade or business to be substantially related, the activity must “contribute importantly to the accomplishment of those purposes.”¹⁷² If a particular activity does not “contribute importantly” to the accomplishment of an organization's exempt purposes, the income realized from the activity does not derive from the conduct of a “related” trade or business. Whether a particular activity “contributes importantly” to the accomplishment of an organization's exempt purposes depends in each case upon the facts and circumstances involved. The regulations specify that in determining whether a particular activity contributes importantly to the accomplishment of an exempt purpose, the size and extent of the activity involved must be considered “in relation to the nature and extent of the exempt function which they purport to serve.”¹⁷³ For example, if an exempt organization generates income from activities that are in part related to the performance of its exempt functions but that are conducted on a larger scale than is reasonably necessary for the performance of such functions, the gross income attributable to that portion of the activities in excess of the needs of exempt functions constitutes gross income from the conduct of an unrelated trade or business.

The sale of religious articles and publications with substantial religious content generally is related to the exempt purposes of a church, as is a church's operation of a religious school since religious training contributes importantly to the exempt purposes of the church. However, it is important to recognize that the accomplishment of a church's exempt purposes does not include a church's need for income or its ultimate use of income. If a church receives income from an unrelated trade or business, the income is taxable even though it is used exclusively for religious purposes such as maintaining the church building, purchasing hymnals, or supporting missions.

Occasionally, a church will operate a bookstore. Is such an enterprise an unrelated trade or business subject to the tax on unrelated business income? This will depend on several considerations, including the following: (1) Is the business operated within the church building, or is it located in another facility? (2) Does the bookstore sell only religious merchandise (books, tapes, records, etc.), or does it also sell “nonreligious” items such as pen and pencil sets, radios, stationery, and film? If it sells nonreligious items what percentage of gross sales consists of such sales? (3) Is the bookstore separately incorporated, or does it come under the church's corporate umbrella? (4) If the bookstore is on church premises, is it open only during those times when the church is in use? (5) Is the bookstore open to the general public? (6) Does the bookstore engage in advertising? (7) What is the relative size of the bookstore's revenue in comparison with church revenues? As has been noted previously, the fact that a bookstore's net earnings are used exclusively for religious purposes is not controlling. The tax on unrelated business income is designed primarily to eliminate the unfair competitive advantage that nonprofit organizations would enjoy if they could sell products to the public in direct competition with taxable enterprises selling the same or similar merchandise. Finally, even if a bookstore's activities suggest that it is an unrelated trade or business, it will not be liable for the tax on unrelated business income if it fits within any of the three exceptions described in the following subsection. For example, a church--operated bookstore will not be considered to be an unrelated trade or business if substantially all of its labor is performed by unpaid volunteers; if it exists primarily for the “convenience” of church members; or if it sells merchandise substantially all of which has been received as gifts or contributions.

c. Exceptions

Section 513(a) of the Code states that the term unrelated trade or business does not include

1. activities in which substantially all the work is performed by unpaid volunteers

2. activities carried on by a church or other charitable organization primarily for the convenience of its members, students, or employees

3. selling merchandise substantially all of which has been received by the exempt organization as gifts or contributions

Several income--producing activities of churches are exempt from the tax on unrelated business income for more than one reason. For example, church bake sales ordinarily are exempt because all of the work is performed by unpaid volunteers, the bakery goods are donated to the church, and the activity is not regularly carried on. Similarly, income from a “thrift shop” operated by a church or other exempt organization ordinarily is exempt from the tax on unrelated business income because all or most of the work is performed by unpaid volunteers and because most of the merchandise sold by the thrift shop is donated. Car washes, fundraising dinners, bazaars, and many similar income--producing activities of churches are exempt from the tax on unrelated business income because of one or more of the exceptions discussed above or because the activity is not regularly carried on.

To illustrate, in one case the IRS argued that a Catholic religious order that owned and maintained a 1600--acre farm that produced crops and livestock for commercial markets was engaged in an unrelated trade or business.¹⁷⁴ The Tax Court, while rejecting the order's contentions that it was not operated for profit and that its farming operation was substantially related to its tax--exempt purpose, concluded that the farm earnings were not unrelated business taxable income since 91 percent of the labor was provided by members of the order without compensation. The court rejected the government's contention that the members of the order received “noncash compensation” for their labor in the form of room and board, since the members would have received such amenities even if they performed no work or the farm operations ceased.

In a similar case, the Tax Court concluded that a religious organization was engaged in an unrelated trade or business.¹⁷⁵ A religious organization was engaged in evangelizing and rehabilitating drug addicts and street people in a communal setting. Persons in the program were expected to work in one of the organization's businesses, which included forestry, house cleaning, and painting. The Tax Court ruled that such businesses were not substantially related to the organization's religious purposes, and therefore the income derived from the businesses was taxable as unrelated business income. The court distinguished the St. Joseph Farms¹⁷⁶ case with respect to the applicability of the volunteer labor exception. In the St. Joseph Farms case, the brothers would have been provided food and shelter even if they were not engaged in farming operations, while in this case the members would not have received food, shelter, clothing, medical care, and other benefits if they did not work.

Bingo games are not an unrelated trade or business so long as (1) wagers are placed, winners are determined, and prizes are distributed in the presence of all persons placing wagers, (2) for--profit organizations are not legally permitted to sponsor bingo games on a commercial basis in the state, and (3) it is lawful for churches to sponsor bingo games under state or local law.¹⁷⁷

Section 512(b) exempts dividends, interest, annuities, royalties, capital gains and losses, and rents from real property from the tax on unrelated business income. These exemptions are limited, however, in two ways. Section 514 of the Code states that the exclusion of dividends, interest, annuities, royalties, rents, and capital gains and losses from the definition of unrelated business income does not apply in the case of unrelated “debt--financed property.” Debt--financed property is defined as any property held to produce income and that is subject to an “acquisition indebtedness,” such as a mortgage, at any time during the tax year.¹⁷⁸ Income derived from debt--financed property generally is included in unrelated business taxable income unless the property falls within one of the following exceptions:

1. Substantially all (85 percent or more) of the property is used for exempt purposes.¹⁷⁹ Property is not used for exempt purposes merely because income derived from the property is expended for exempt purposes. If less than 85 percent of the use of property is devoted to exempt purposes, only that part of the property that is not used to further exempt purposes is treated as unrelated debt--financed property.¹⁸⁰

2. Income from debt--financed property is otherwise taken into account in computing the gross income of any unrelated trade or business.

3. The property is used in a trade or business that is substantially supported by volunteer workers; that is carried on primarily for the convenience of its members, students, or employees; or that involves the selling of merchandise substantially all of which has been received by the organization as gifts or contributions.¹⁸¹

In addition, the Code specifies that if an exempt organization acquires real property mainly to use it for exempt purposes within 10 years, it will not be treated as debt--financed property if it is in the neighborhood of other property that the organization uses for exempt purposes and if the intent to use the property for exempt purposes within 10 years is not abandoned. This exception to the definition of debt--financed property is referred to as the neighborhood land rule.¹⁸² The neighborhood land rule does not apply to property 10 years after its acquisition. Further, the rule applies after the first 5 years only if the organization satisfies the Internal Revenue Service that use of the land for exempt purposes is reasonably certain before the 10--year period expires. The organization need not show binding contracts to satisfy this requirement; but it must have a definite plan detailing a specific improvement and a completion date, and it must show some affirmative action toward the fulfillment of the plan. This information should be forwarded to the Assistant Commissioner  (Employee Plans and Exempt Organizations), 1111 Constitution Avenue, N.W., Washington, D.C. 20224, for a ruling at least 90 days before the end of the fifth year after acquisition of the land. The income tax regulations authorize the IRS to grant a reasonable extension of time for requesting the ruling if the organization can show good cause.¹⁸³

If the neighborhood land rule does not apply because the acquired land is not in the neighborhood of other land used for an organization's exempt purposes, or because the organization fails to establish after the first 5 years of the 10--year period that the property will be used for exempt purposes, but the land is used eventually by the organization for its exempt purposes within the 10--year period, the property is not treated as debt--financed property for any period before the conversion.

The neighborhood land rule applies to any structure on the land when acquired, or to the land occupied by the structure, only so long as the intended future use of the land in furtherance of the organization's exempt purpose requires that the structure be demolished or removed in order to use the land in this manner. Thus, during the first 5 years after acquisition (and for later years if there is a favorable ruling), improved property is not debt financed so long as the organization does not abandon its intent to demolish the existing structures and use the land in furtherance of its exempt purpose. If an actual demolition of these structures occurs, the use made of the land need not be the one originally intended as long as its use furthers the organization's exempt purpose. The neighborhood land rule does not apply to structures erected on land after its acquisition.

When the neighborhood land rule does not initially apply, but the land is used eventually for exempt purposes, a refund or credit of any overpaid taxes will be allowed for a prior tax year. A claim must be filed within one year after the close of the tax year in which the property is actually used for exempt purposes.

The neighborhood land rule applies to churches and associations and conventions of churches, but with two important differences:

1. The period during which the organization must demonstrate the intent to use the acquired property for exempt purposes is increased from 10 to 15 years, and

2. The land need not be in the “neighborhood” of other property of the organization that is used for exempt purposes.

Accordingly, if a church or an association or convention of churches acquires real property for the primary purpose of using the land in the exercise or performance of its exempt purposes, beginning within 15 years after the time of acquisition, the property is not treated as debt--financed property as long as the organization does not abandon its intent to use the land in this manner within the 15--year period. This exception for a church or association or convention of churches does not apply to any property after the 15--year period expires. Further, this rule will apply after the first 5 years of the 15--year period only if the church or convention or association of churches establishes to the satisfaction of the Internal Revenue Service that use of the acquired land in furtherance of the organization's exempt purposes is reasonably certain before the 15--year period expires.

If a church or an association or convention of churches (for the period after the first 5 years of the 15--year period) cannot establish to the satisfaction of the Internal Revenue Service that use of acquired property for its exempt purpose is reasonably certain within the 15--year period, but the land is in fact converted to an exempt use within the 15--year period, the land is not to be treated as debt--financed property for any period before the conversion. The same rule for demolition or removal of structures (discussed above) applies to a church or an association or convention of churches.

The second limitation on the exemption of dividends, interest, annuities, royalties, capital gains and losses, and rents from the tax on unrelated business income relates to the interest, annuities, royalties, and rents of organizations that are controlled by a tax--exempt organization. Under section 512(b)(13) of the Code, the exclusion of interest, annuities, royalties, and rents from the definition of unrelated business income does not apply if such amounts are derived from organizations that are controlled by a church or other tax--exempt organization. When a tax--exempt organization controls another organization, the interest, annuities, royalties, and rents from the controlled organization are taxable to the controlling organization at a specific ratio depending on whether the controlled organization is exempt or nonexempt. All deductions directly connected with amounts included in an organization's gross income under this provision are allowed. The organization from which the interest, annuities, royalties, and rents are received is called the controlled organization, and the exempt organization receiving these amounts is called the controlling organization. In the case of a nonstock organization the term control means that at least 80 percent of the directors or trustees of such organization are either representatives of or directly or indirectly controlled by the controlling organization. A trustee or director is controlled by an exempt organization if the organization has the power to remove the trustee or director and designate a new trustee or director.

When the controlled organization is an exempt organization, the interest, annuities, royalties, and rents received by the controlling organization are includable in its unrelated business taxable income in the same ratio as the ratio of the controlled organization's unrelated business taxable income to its taxable income determined as if the exempt controlled organization were not tax--exempt.

d. Computation of the Tax

Section 511 imposes a tax on “unrelated business taxable income.” Section 512 defines unrelated business taxable income as the gross income derived from any unrelated trade or business regularly carried on less the deductions directly connected with such trade or business, both computed with the modifications set forth in section 512(b). To qualify as an allowable deduction, an expense must qualify as an income tax deduction and be directly connected with the carrying on of the unrelated trade or business. Expenses that are incurred to carry out both an unrelated trade or business and an organization's exempt functions must be allocated between the two uses on a reasonable basis. For example, if an exempt organization pays its president an annual salary of $60,000, and the president devotes approximately 10 percent of his time to an unrelated trade or business conducted by the organization, a deduction of $6,000 (10 percent of $60,000) would be allowable as a salary expense in computing unrelated business taxable income.

Expenses attributable to an unrelated trade or business that exploits exempt activities for commercial gain, such as the sale of commercial advertising in the periodical of an exempt organization, are deductible if (1) the unrelated trade or business is the kind carried on for profit by taxable organizations, (2) the activity being exploited is of a type normally carried on by taxable corporations, (3) the expenses exceed the income from or attributable to the exempt activity, and (4) the allocation of the excess expenses to the unrelated business does not result in a loss from the unrelated trade or business. Thus, the expenses are allocated first to the exempt activity to the extent of any income derived from or attributable to that activity. Any excess expense is allocated to the unrelated business, but only to the extent that the allocation does not result in a loss carryover or carryback to the unrelated business.

In addition to allowable deductions, an exempt organization is entitled to various “modifications” in computing unrelated business taxable income. These include (1) dividends, interest, annuities, and royalties, except with respect to the limitations that apply in connection with debt--financed property and controlled organizations;¹⁸⁴ (2) rents from real property; (3) capital gains and losses; (4) charitable contributions of up to 10 percent of unrelated business taxable income; and (5) a specific deduction of $1,000. The specific deduction is limited to $1,000 regardless of the number of unrelated businesses in which an organization is engaged. An exception is provided in the case of a diocese, province of a religious order, or a convention or association of churches that may claim for each parish, individual church, district, or other local unit a specific deduction limited to the lower of $1,000 or the gross income derived from an unrelated trade or business regularly carried on by the local unit.¹⁸⁵ This exception applies only to parishes, districts, or other local units that are not separate legal entities, but are components of a larger entity (diocese, province, convention or association of churches) filing Form 990--T (the unrelated business income tax return). The parent organization must file a return reporting the unrelated business gross income and related deductions of all units that are not separate legal entities. The local units cannot file separate returns. However, each local unit that is separately incorporated must file its own return and cannot include, or be included with, any other entity.

All tax--exempt organizations subject to the tax on unrelated business income must include, with this income, unrelated debt--financed income from debt--financed property. For each debt--financed property, the unrelated debt--financed income is a percentage (not over 100 percent) of the total gross income derived during a tax year from the property. This percentage is the “debt/basis” percentage, and the formula for deriving unrelated debt--financed income is:

average acquisition indebtedness
___________________________     x     gross income from debt--financed property

average adjusted basis

Average acquisition indebtedness is the average amount of outstanding principal debt during the part of the tax year that the organization holds the property. Average adjusted basis is the average of the adjusted basis of the property as of the first day and the last day that the organization holds the property during the year. In computing unrelated debt--financed income, an organization may deduct those expenses directly connected with the property multiplied times the “debt\basis” percentage.

To illustrate, assume that an exempt organization owns a building that is debt--financed. The organization rents the building to another organization, and receives $10,000 in rental income. If the average adjusted basis of the building for the year was $100,000, and the average acquisition indebtedness was $50,000, the debt/basis percentage is 50 percent and the unrelated debt--financed income with respect to the building was $5,000 ($10,000 x 50 percent).

Once all available deductions and modifications have been considered and unrelated business taxable income is determined, the tax is computed by multiplying unrelated business taxable income times the corporate income tax rates.

e. Returns

An exempt organization subject to the tax on unrelated business income must file its income tax return on Form 990--T (“Exempt Organization Business Income Tax Return”) and attach any required supporting schedules and forms. The return is filed with the appropriate IRS Service Center.

This return is required only if the gross income from an unrelated trade or business is $1,000 or more. The obligation to file the 990--T form is in addition to the obligation to file any other required forms or returns. The 990--T must be filed not later than the fifteenth day of the fifth month after the tax year ends (i.e., May 15 of the following year for an organization on a calendar year basis).

Beginning in 1987, tax--exempt organizations must make quarterly payments of estimated tax on unrelated business income. An organization must make estimated tax payments if it expects its tax (unrelated business income tax less credits) to be $40 or more. Estimated tax payments generally are due by the fifteenth day of the fourth, sixth, ninth, and twelfth months of the organization's tax year. For organizations on a calendar year basis, the quarterly estimated payments are due on the fifteenth day of April, June, September, and the following January. Organizations that fail to pay the proper estimated tax payment when due may be charged an underpayment penalty. To avoid the estimated tax penalty, the amount of estimated tax payments required by the organization is 90 percent. Tax--exempt corporations can use IRS Form 1120--W to figure their estimated tax. Estimated tax payments should be deposited with a federal bank (using Form 8109).

f. Effect on Tax--Exempt Status

A tax--exempt organization will not lose its exempt status by engaging in an unrelated trade or business so long as the trade or business does not constitute more than an insubstantial part of its activities.

Social Security Taxes and Churches

Unemployment Taxes and Churches

State Taxes