February 03, 2009

Court Rules Against IRS in Church-Audit Case

The Internal Revenue Service has suffered another setback in its effort to pursue an audit of a church in Minnesota in a case that has ramifications for the tax agency and churches nationwide.

A U.S. District Court judge in Minneapolis ruled that the Living Word Christian Center, in Brooklyn Park, Minn., does not have to comply with an IRS summons for information because the summons was not authorized by a government official of sufficient rank.

The ruling by Judge Ann D. Montgomery concurs with a decision in December by U.S. Magistrate Judge Jeffrey J. Keyes.

Some tax-law experts have said that the IRS’s defeat could spur challenges to audits by other churches and force the IRS to engage in a lengthy, formal rule-making process to determine who has the authority to order an investigation into a church’s finances.

The IRS began to investigate Living Word in April 2007, following reports that the Rev. Mac Hammond had endorsed U.S. Rep. Michele Bachmann, a Minnesota Republican, from the pulpit—an act that would violate charity tax laws.

In investigating that allegation, the IRS found that the church had engaged in financial transactions that may have improperly benefited Mr. Hammond, and possibly called into question the congregation’s tax-exempt status. Living Word leased planes owned by Mr. Hammond, and the pastor borrowed money from the church, which later forgave a portion of the debt, according to court documents.

In a letter to his congregation last year, Mr. Hammond said that all of his compensation, including the loans and aircraft leases, had been approved by the church’s Board of Directors and had followed IRS guidelines.

In June 2007, the church replied to some of the IRS’s requests for information, but refused to answer later questions about its operations and canceled a scheduled conference with tax agents.

Living Word argued that an April 2007 letter from the IRS alerting it about an inquiry into its finances, signed by the IRS’s director of exempt organizations for examinations, violated the Church Audit Procedures Act, a law that sets forth specific steps the IRS must follow in examinations of churches to protect against government intrusion into church affairs.

After that law was enacted in 1984, Treasury Department issued regulations that the lowest-ranking IRS official who could approve a church audit was a regional commissioner, just one level of authority below the IRS commissioner.

But the tax agency was reorganized in a 1998 law that eliminated the regional commissioner position along with a geographic structure that divided the nation into quadrants. The newly organized IRS was based on categories of taxpayers, such as small businesses and tax-exempt organizations.

After the reorganization, the IRS gave the authority to order a church audit to the director of exempt organizations for examinations — four management levels below the commissioner, according to Judge Keyes’ analysis. That authority was delegated not by a formal rule-making process but by the IRS’s employee manual, which does not carry the force of law and does not have the same authority as formal regulations, Mr. Keyes said.

Mr. Keyes ultimately denied enforcement of the summons because he said the IRS official who approved the church tax inquiry was not an appropriate high-level Treasury official.

Judge Montgomery said she agreed with Mr. Keyes. Ms. Montgomery rejected several IRS arguments to overturn Judge Keyes’ opinion. One, she said, was the IRS’s view that the director of exempt organizations for examination has more expertise in tax-exempt matters than did a regional commissioner and thus was a better candidate to start a church tax audit.

Eric Kelderman contributed to this article.