Appeal from the United States District Court for the Eastern District of Washington. D.C. No. CV-91-024-JLQ. Justin L. Quackenbush, Chief District Judge, Presiding.
Before: Jerome Farris, Warren J. Ferguson, and Dorothy W. Nelson, Circuit Judges. Opinion by Judge Ferguson.
The Internal Revenue Service (IRS) appeals from the district court's denial of the IRS' motion to enforce two summonses, one against C. E. Hobbs Foundation for Religious Training and Education, Inc. (Foundation) and the other against the Washington Trust Bank (Bank) as third party record keeper of the Foundation's financial records. The district court refused to enforce either summons because it found that the IRS had failed to show that the requested documents were necessary to determine whether the Foundation was liable for any taxes or to determine whether the Foundation actually was a church. See 26 U.S.C. § 7611(b)(1). We find that the district court clearly erred in determining that the IRS failed to make the required showing of necessity. In addition, the district court erred in applying section 7611(b)(1) to the Bank summons. Therefore, we reverse the order denying enforcement of both summonses.
Criminal investigations of the Foundation and subsequent newspaper reports prompted the IRS to believe that the Foundation was not tax-exempt because it was not being operated for religious purposes and because Foundation profits were inuring to private individuals. A search warrant obtained by local law enforcement officials alleged that one of the Foundation's central teachings was to encourage members to participate in "sharing," which consisted of sexual activity between adult church members and minors. A second search warrant alleged that the Foundation was selling beer and wine without a license. Subsequent newspaper reports described the Foundation's opulent grounds, nightclub-like furnishings, and weekend-long parties for members. One news report stated that the Foundation had transferred its assets to a trust, with Reverend Hobbs' son and his female companion as the sole trustees.
The IRS initiated a church tax inquiry on May 7, 1990, by sending the Foundation a notice of church tax inquiry, as required by 26 U.S.C. § 7611(a)(3), stating that the IRS had reason to believe that the Foundation might not be tax-exempt or might be liable for tax. The letter further stated that the IRS had reason to believe that the Foundation's character, purpose, or method of operation was different from that stated in its application for tax-exempt status, and that the Foundation was not organized or operated for an exempt purpose. The IRS indicated in the letter that its reasonable belief was based on the police investigations and newspaper articles discussed above.
On July 30, 1990, the IRS sent the Foundation a notice of examination, informing the Foundation that it had a right to a conference with IRS officials. See 26 U.S.C. § 7611(b)(2)-(3). The IRS included copies of all of the materials that it believed supported its reasonable belief in the necessity of the inquiry and examination. Subsequently, two conferences were held at which the IRS requested the production of certain documents. The Foundation provided some, but not all of the materials requested by the IRS.
Not satisfied by the documents produced by the Foundation, the IRS issued two summonses, one to the Foundation and one to the Bank. The Foundation summons requests production of all of the church's accounting ledgers and journals, all records of church assets, all organizational and religious records, and all tax-related records. The Bank summons requests all financial records pertaining to the Foundation.
On January 22, 1991, the Foundation moved to quash both summonses, contending that the IRS had not demonstrated that the requested documents were necessary in determining liability, as required by the statute; that the IRS investigation violated the Foundation's constitutional rights; and that the investigation was being conducted for an improper purpose. On April 16, 1991, the IRS petitioned to enforce both summonses and opposed the petition to quash the bank summons.*fn1 The IRS argued that it had demonstrated that the documents were relevant to its investigation and that the statute requires only a showing of relevance. In the alternative, the IRS argued that if the standard required by the district court was higher than relevance, the IRS had demonstrated the requisite level of necessity.
The district court consolidated the motions concerning the two summonses and held a hearing. The district court granted the Foundation's petition to quash the summons for the Bank records and refused to enforce the summons for the Foundation records. C.E. Hobbs Foundation for Religious Training and Educ. v. United States, 91-2 U.S. Tax Cas. (CCH) 50444 (E.D. Wash. 1991). The IRS appeals from the district court's decision.
II. The Foundation Summons
Section 7611 of the tax code affords churches special protections in the audit context. First, the IRS may initiate a church tax inquiry only if certain procedural requirements are met. 26 U.S.C. § 7611(a). These procedural requirements are the heart of the statute, in that they afford religious institutions extensive safeguards from having to defend an audit at all. After an inquiry has been validly initiated, the IRS may examine church records "to the extent necessary to determine liability . . . ." 26 U.S.C. § 7611(b)(1)(A). Likewise, the IRS may examine religious activities "to the extent necessary to determine whether the organization claiming to be a church is a church for any period." 26 U.S.C. § 7611(b)(1)(B).
The district court found that the IRS failed even to show that it was conducting a valid investigation. Thus as a threshold matter we must determine if the IRS properly initiated a church tax inquiry.
In its initial notice of church tax inquiry, the IRS stated in writing that it had reason to believe that the church was operating for purposes other than those that were tax-exempt, citing the criminal investigations, the newspaper articles, and the alleged transfer of church property to non-exempt entities as the reasons for its belief. The IRS then complied with all other procedural requirements of section 7611. No more is required of the IRS in order to initiate an inquiry. See 26 U.S.C. § 7611(a)(1)-(2). The district court stated that the IRS lacked sufficient "evidence" to prove that it was conducting a valid investigation, presumably because the district court felt the evidence was not sufficiently probative. It is clear from the statute that information relied on by the IRS in initiating a valid inquiry need provide the IRS ...